The government wants to help you save for retirement by giving you incentives like tax-deferred growth and deductible contributions through IRAs and work-sponsored plans.
But while the government forgoes taxes on the front-end, it doesn’t want to end up entirely empty-handed. At the age of 70 1/2, you’re required to start taking withdrawals from most retirement accounts; otherwise, you will face stiff penalties. These are known as required minimum distributions, or RMDs. They’re intended to prevent individuals from hoarding money, so the IRS can eventually get its cut of your savings.
Required Minimum Distributions (RMDs)
Accounts with Required Minimum Distributions
All employer-sponsored retirement plans must follow these rules, including 401k, 403b, 457b, and profit-sharing plans. Individual plans, such as traditional IRAs, SEP-IRAs, and SIMPLE IRAs, are also subject to RMDs. The Roth IRA is a notable distinction because it does not have any withdrawal requirements since tax was already paid on contributions up front. The Roth 401k does have withdrawal requirements, but only after the original account holder has died.
When to Start Taking Distributions
With one exception, you must begin taking RMDs by April 1st of the year immediately following the year you turn 70 1/2. You will need to calculate the exact amount required by the IRS to make sure your distribution is adequate. You are allowed, of course, to withdraw as much as you want above the minimum requirement.
If you’re still working, you can delay taking RMDs from your employer-sponsored retirement plan until April 1st of the year after you retire. This is known as the “still working” exception and does not apply to IRAs. In other words, if you turn 70 1/2 and are still working, you must start RMDs from your IRA even though you can delay taking them from your 401k.
Keep in mind that if you wait until April 1st of the year immediately following your 70 1/2 birthday, you will need to take two RMDs that year, which could have a significant effect on your income tax bracket and liability.
Penalties
If you fail to take distributions, the federal government determines your RMD based on a report of your accounts from your financial management firm. Then, it assesses you a penalty for 50% of the amount you were short. This tax is steep, which is why it’s so important to remember to take RMDs and get the amount accurate. However, if you didn’t take out enough due to an error, and you’re currently trying to fix that error, you can file an appeal with the IRS to get the extra penalty amount waived.
How Much to Withdraw
Your financial management firm can calculate it for you, or you can use an RMD calculator. The amount you have to withdraw is based on your account balance, your age, and the age of your spouse if you are married. The IRS produces life expectancy tables each year from which it determines your RMD so that, ideally, you draw down the majority of your account values within your lifetime.
You do not need to make the withdrawal at any specific time or on any specific schedule. The only requirement is that your total withdrawals add up to at least your RMD amount by the end of the year.
If you have more than one retirement account of the same type (e.g. multiple IRAs), it doesn’t matter from which account or combination of accounts you withdraw, just as long as the total amount withdrawn adds up to your RMD. If you have more than one account type (such as one traditional IRA and one 401k), you will need to make separate calculations and withdrawals from each account. That said, if you’re no longer working and have a 401k or other employer-sponsored retirement plan, consider rolling it into an IRA.
Charitable Contributions
If you’re required to take RMDs from your IRA, there is one way to avoid paying tax on the distribution: donate it to a charity. The charity must be an IRS qualified charity and you can donate up to $100,000. The donation must occur via a trustee to trustee transfer.
In other words, the company that administers your IRA transfers your donation directly to the destination charity, without it ever touching your hands. This is the only way to ensure you won’t be taxed on the entire amount. The donation is not included in your taxable income and qualified IRA transfers are not subject to regular charitable contribution limits. The current legislation allowing this, however, is set to expire after 2011, though many interested parties are doing what they can to extend it.
Additional Considerations
- RMD amounts don’t receive any special tax considerations. The distributions are taxed in the same way as any other withdrawal from the account would be taxed.
- Unlike a SEPP or 72t plan, you can take out more than the minimum and you can put money into the account. However, you can’t roll the distribution from one account into another, and thereby avoid paying taxes.
- Your financial management firm is required to tell you whether you have an RMD due by January 31st of the following year. However, it may not calculate it for you unless you ask.
Final Word
Pulling money out of your retirement accounts can require as much or more planning as saving for retirement. Make sure you are prepared for the tax consequences of required minimum distributions. Remember, the taxes you’ll pay on withdrawals aren’t nearly as bad as the penalties you’ll face if you don’t withdraw enough.
Have you planned for RMDs? Can you recommend any strategies to deal with them?
