Everything You Need to Know About RMDs
By Russell W. Hall, CFP®
It seems like few retirement account rules are more misunderstood than the required minimum distribution (RMD). So, what is the RMD, and how does it affect you?
First, a refresher on retirement accounts like the IRA, 401(k), and 403(b), since they are where the RMD rule primarily applies. Roth IRA accounts are different, and we’ll touch on them later.
When you save to retirement accounts, you’re contributing pre-tax dollars (or getting a tax break for contributing if you have an IRA). Then, the money can grow tax-free in those plans, hopefully for quite a while.
That tax-free growth is a good deal, but we all know there is no free lunch—and the government wants to get its share of those retirement savings eventually. To do that, the IRS requires a minimum distribution starting the year after a person reaches 70.5 years old (we’ve never heard a good reason why the half-year is part of that equation).
Although there is legislation pending to push the first RMD out to age 72 or even beyond, at the time of this writing, the requirement still starts at 70.5.
How RMDs Are Taxed
The distributions are taxed as ordinary income, on which you must pay taxes. Technically, you have until April 1 of the next year after you turn 70.5 years old to take the first distribution, but most people don’t wait because they would then have two RMDs that next year. (We’ve recommended this strategy a handful of times, usually when someone is retiring just after they’ve turned 70.5 and it makes sense to delay the additional income from the RMD.)
To calculate the RMD, you take the account balance on December 31 of the previous year and a “life expectancy” factor that the IRS provides. For instance, if your IRA was worth $120,000 on December 31, 2019, and you turned 70 in January 2020, you would use the factor provided for a 70-year-old as follows: $120,000 ÷ 27.4 = $4,380.
That means you’d need to withdraw at least $4,380 by December 31, 2020, or face a very stiff 50% penalty from the IRS on the amount you didn’t withdraw (and be forced to take the distribution anyway!). You can also choose to withhold federal and state taxes from the distribution, if applicable.
Rules and Exceptions to RMD Amounts
As with anything related to taxes, why be simple when you can make it complicated? RMDs have several rules and exceptions, and the following are a few that might affect you.
First, are you still working at 70.5? You don’t have to take an RMD from the 401(k) or 403(b) that you have with your current employer. But, if you have an IRA or another old 401(k), you must take RMDs from those.
Second and along those same lines, if you have several IRA accounts (including a SEP or SIMPLE IRA), you add them all up for the calculation, but you can take the distribution from just one account or any of them. However, that’s not true for all types of retirement accounts, and 401(k) or 403(b) RMDs must be calculated and distributed separately.
Usually, the IRA custodian or plan sponsor will notify account owners if they are required to take an RMD and will help calculate and take the distribution. A word of caution that some companies are more aggressive in this regard—we’ve had required distributions sent out from 403(b) accounts even though the participant was still working and contributing.
Third, are you married to someone more than 10 years younger than you? You use a different type of life expectancy factor (joint life), which allows the distributions to be smaller. The idea is that the retirement account won’t be withdrawn from as fast, which will leave more money for the younger spouse.
We have also been seeing inherited retirement accounts more and more. For those, the RMD starts the year after the year that the original IRA owner passes away and the account is inherited, no matter the age of the inheritor. There’s a third life expectancy factor type (single life), which lets the distributions be spread out even longer. And, inherited accounts cannot be commingled with your own retirement accounts.
Earlier, we said that Roth IRAs are different. Because after-tax dollars are contributed to a Roth IRA, there is no RMD requirement during the account owner’s lifetime. However, inherited Roth IRAs do have RMDs, although the distributions are not taxable to the inheritor.
Incorporating RMDs into Your Retirement Plan
So far, we’ve talked about when you need to take RMDs, but we haven’t touched on what you can do with the proceeds. For our clients, we usually calculate and withdraw the RMDs toward the end of the year. The amount can be withdrawn all at once or throughout the year. Some clients take a monthly distribution as part of their regular income.
What if you don’t need the proceeds from the RMD to live on? You cannot reinvest the money into another retirement account, but you can send it to a taxable account (like a joint, community property, or trust account) and reinvest it there. It may also be beneficial for you to send part or all of your RMD directly to charity as a qualified charitable distribution.
If you have specific questions about an IRA rollover and how these rules affect you, our Fullerton financial advisory firm is happy to talk through your situation. Schedule a 15-minute discovery call with a fee-only financial advisor.