Earlier on, there were no retirement programs available for people to generate savings to meet expenses for when they retired and no longer earning via a stable income. Eventually, with the development of the banking system, people began saving their money in bank accounts. However, as these bank accounts were open accounts with no real withdrawal restrictions, many people would often dip in and deplete their savings before they entered retirement. The importance of retirement savings grew with time and with exposure to world events such as the financial welfare program that was started in Prussia, a former German state.
According to certain records, municipal workers in the US started receiving public pensions from around the mid-1800s. However, it was not until 1920 that the Federal government established a pension plan for its employees. Individual Retirement Accounts (IRAs) were introduced later in 1974 to enable employees to increase their ownership and to take control of their retirement savings. IRAs became popular with millions of people taking advantage of the account to grow their retirement corpus while availing significant tax benefits. In 1978, the 401(k) employer-sponsored plans were introduced to further enable retirees to save better for their golden years. However, over the years, as limitations of both accounts came to light, Roth IRAs were introduced in 1997, offering more advantageous features and enhanced tax benefits.
The popularity of these accounts led to a decline in traditional pension schemes. Presently, these retirement savings vehicles are a critical source of retirement income for the majority of Americans. But even though these accounts come with several benefits, they have specific rules and stipulations, which are important to know about and understand. One such must-know stipulation is the Required Minimum Distribution (RMD).
Let’s take an in-depth look at what you should know about RMDs and how it affects your tax position during retirement:
What are Required Minimum Distributions (RMDs)?
Required Minimum Distributions or RMDs are a defined sum that the Internal Revenue Service (IRS) mandates you to withdraw each year from your eligible tax-deferred retirement savings accounts. Generally, RMDs begin by April 1st of the year after you turn 72 years old.
Not withdrawing your mandatory RMDs or failing to take the drawings in full each year can result in penalties (up to 50% of the RMD shortfall). However, if you want, you may distribute more from your retirement accounts, without any charges.
For example: If your RMD is $30,000, but you withdraw only $20,000 from your IRA, you will owe the IRS an excess accumulation penalty of up to $5,000 (50% of the difference amount, i.e., $10,000 in this case). However, if you withdraw $31,000 from your IRA, which is higher than your RMD, you will not have to pay a penalty or any other charges, provided you meet the withdrawal eligibility criteria, such as being 59 ½ years old, etc.
The money you withdraw each year is considered a part of your annual taxable income, excluding any amount that has already been taxed previously.
What was the purpose of RMDs?
RMDs were introduced by the IRS to prevent people from deferring taxes indefinitely on their retirement savings accounts. Contributions to a Traditional IRA and a 401(k) are made with pre-tax dollars; i.e, they are tax-free when you make the contribution and grow tax-free in the account. However, you must pay taxes on all the proceeds from these accounts (including capital gains and dividends) when you make withdrawals.
The government noticed that investors continued to hold the money in their retirement accounts, thereby deferring their taxes for a long time. Once they retired and withdrew the money, there was a large tax bill. This seemed counterproductive to the hopes of the IRS as the retirement accounts were intended to help people save for a comfortable retirement. Moreover, a deferred tax amount was a stress on the exchequer as well.
Hence, to discourage retirees from deferring their taxes on their retirement accounts by never taking distributions if they do not need the funds, the IRS established the RMD rule to collect taxes periodically on retirement account savings.
Retirement Savings Accounts That Have RMD Rules
RMD rules apply to the below retirement savings accounts:
- Traditional IRAs
- Nearly all 401(k), 457 (b), and 403(b) accounts
- Rollover IRAs
- SIMPLE IRAs
- SEP IRAs
- Most small business accounts
- Other defined contribution plans
- Profit-sharing plans
- Thrift savings plan (TSP)
However, there is no RMD rule for Roth IRA accounts.
How do RMDs work?
Generally, traditional IRAs and other employer-sponsored retirement savings plans like a 401(k), etc., permit you to contribute money up to a specific limit.
As per the Tax Cuts and Jobs Act (tax reform), the annual contribution limitations are:
- Traditional IRAs: $6,000
- Traditional IRAs for account holders above 50 years: $7,000
- Roth IRAs: $6,000
- Roth IRAs for account holders above 50 years: $7,000
- 401(k) accounts: $19,500
- 401(k) accounts for account holders above 50 years: $26,000
These contributions are exempt from federal taxes. But you cannot hold your funds in these accounts indefinitely because the IRS requires you to start taking withdrawals from such retirement savings accounts by the age of 70 ½. These mandatory drawings or withdrawals are referred to as required minimum distributions (RMDs).
The withdrawal age for RMDs was changed to 72 years. You must take your RMDs each year before the set deadline to avoid hefty penalties and taxes levied by the IRS.
What is the deadline to take RMDs each year?
The IRS mandates you to take the RMDs from your retirement savings accounts by December 31st of each year. But, specifically, for an IRA, you can delay your first distribution until April 1st of the year in which you turn 72. However, if you opt to delay the IRA RMD, the IRS will ask you to take your first and second RMD, both in the same year of taxation.
It is critical to note that the April 1st deadline is applicable only for the first year of the RMD. For all subsequent years, the RMD must be taken by December 31st of the year.
Further, the IRS also mandates that beneficiaries take the RMDs in the year in which the account holder passes away. In case of failure, the estate will be levied a penalty for not taking the RMD in that year.
How to calculate RMDs
RMDs for an annual year can be determined with the help of a specific formula.
The formula divides the total retirement account balance (at the end of the previous calendar year) by the applicable distribution period, from the IRS calendar.
| Required Minimum Distribution = Total Retirement Account Balance/Distribution period |
What is the distribution period for RMDs?
The distribution period for RMDs is determined by fixed data tables authored by the IRS that pegs your age to the average life expectancy of an American citizen. For further unification of the varied life stages and lifestyles, the IRS has factored in and defined certain criteria to use that will help you to figure out which of the two tables you must pick.
The IRS has issued the IRS Uniform Lifetime Table, which lists your age against a life expectancy factor. Your age for this purpose is the age as on your birthday of the current year. This table is applicable for those account holders who are:
- Unmarried
- Have married spouses who are not more than ten years younger
- Have married spouses who are not the sole beneficiaries of their account
But, in case your spouse is the only beneficiary of your retirement savings account or if your spouse is ten or more years younger than you are, the IRS requires you to determine your life expectancy component for the above formula from the IRS Joint Life Expectancy Table. This table allocates a life expectancy factor conforming to you and your spouse’s age as on your birthday in the current year.
RMD calculations using the IRS Uniform Table:
For instance, Mr. Y, who is married, celebrated his 72nd birthday in 2020. He had $100,000 in his IRA balance as of December 31st of 2019. His wife, Mrs. Y, was also going to turn 72 in 2020. Hence, Mr. Y would use the IRS Uniform Lifetime Table to calculate his RMD for the current year.
As for Mr. Y in this case, the applicable life expectancy factor according to the IRS Uniform Lifetime Table is 25.6.
Hence, Mr. Y is required to take out not less than $3,906.25 annually from his IRA account ($100,000/25.6 = 3,906.25) starting from the year in which he turned 72.
This same calculation can be applied for any person in a similar situation and other RMD applicable accounts such as a 401(k).
RMD calculation when the IRS Joint Life Expectancy Table is applied:
Let us assume that Mr. Z, who is married, turned 75 years old. He had $100,000 in his IRA account. His wife, Mrs. Z, turned 63. She happens to be the sole beneficiary of Mr. Z’s IRA account. In this case, given the age gap between the couple is more than ten years, and she is the sole beneficiary after Mr.Z’s passing, Mr. Z should choose the IRS Joint Life Expectancy Table to calculate his RMD.
In this situation, as per the IRS Joint Life Expectancy Table, the applicable life expectancy factor for Mr. Z is 25.
Therefore, Mr. Z will have to take $4,000 as annual distributions from his IRA account ($100,000/25 = $4,000)
This same calculation can be applied for any person(s) in similar situations and other RMD applicable accounts such as a 401(k).
Please note that in both cases, Mr. Y and Mr. Z can take distributions above the RMD limit from their IRA account. However, if they withdraw a value lesser than the RMD sum, they will be liable to pay a penalty, which can be as high as 50% of the sum not withdrawn. Moreover, the penalty would continue until the difference is covered by Mr. Y and Mr. Z.
Should I calculate my RMD amount?
While it is good to know your RMD amount and to be able to verify it, it is usually the custodian of your retirement savings accounts or the administrator of the plan who is responsible to determine your RMD and report the same to the IRS. Since 401(k) plans are employer-sponsored, your employer would calculate your RMD. However, IRA accounts are held by custodians. These custodians typically include banks, trust companies, brokerage companies, federally insured credit unions, or any other institution authorized by the IRS to act as an IRA custodian. Hence, the applicable custodian would calculate your RMD for an IRA.
The year-end account value is reported by the trustee to the IRA owner through Form 5498. In some cases, the trustee also calculates the RMD. Nonetheless, the IRA administrator continues to still be ultimately responsible for determining the RMD amount for the year.
What are the important parameters to know while calculating your RMDs?
You may not need to calculate your RMDs yourself, but know that they have a direct monetary bearing on your retirement savings. It is always advisable to stay informed about your withdrawal mandates and deadlines to avoid paying any penalties.
Some important points that you should know about RMDs are:
- Some qualified retirement plans permit their participants under certain terms and conditions to delay the commencement of their RMDs until they retire. This benefit is given even if the participant is over the age of 72. However, not all employers or custodians offer this feature, and hence, you must check with your employer or account custodian should you require such a facility and if they provide such deferment of the RMDs.
- As mentioned earlier, you are eligible to take more than the mandatory distribution. You can take even 100% from your balance in your retirement savings account in the first year. However, be mindful because withdrawals are considered a part of your taxable income, and hence, you may be required to pay a hefty tax bill on large sum distributions.
- The IRS often changes certain criteria that govern the RMD rules such as the eligible age, calculation criterion, etc. So, when determining your RMD for the annual year, be sure to check the official website of the IRS first. Look out for the latest information on RMDs and cross-verify your calculation worksheets.
- When calculating your RMDs, make sure to use the correct calculation table. For this purpose, understand the RMD rules and match them as per your financial condition. For example, if your spouse is more than ten years older than you, you need to use a different RMD calculation table than if your spouse and you are in a similar age group.
- More importantly, you need to calculate your RMD separately for each account where the RMD rule is applicable. This is applicable even if you have multiple IRAs in your name. That said, you will also pay a separate penalty for each account if you fail to take RMDs from every one of those accounts on time or up to the specific amount.
- You have the option to take your mandatory distributions either in a lump sum or through incremental withdrawals spread across the year. However, in totality, you need to withdraw your RMD amount before December 31st of the year.
You also have the option to divert your RMDs towards charity. You may use a qualified charitable distribution (QCD) to meet all or a part of your RMD obligation. However, the QCD should be paid directly from your IRA and must be made to an eligible charity. This benefit is available only for IRA owners who are 70.5 years or older. The maximum exemption under this rule is $100,000. To illustrate, let’s assume that your RMD was $10,000 and you made a QCD for $6,000. In that case, you would only need to take out $4,000 more from your account to satisfy your RMD level.
Are RMDs applicable for inherited IRAs?
RMDs are applicable even in an inherited IRA. But in an inherited IRA, the IRS mandates you to take annual distributions irrespective of your age. Similar to RMD rules that are applicable for other types of retirement accounts, if you do not take the set distributions, you will be liable to pay a 50% tax penalty on the RMD figure not withdrawn. However, rules for spouses and non-spouses are different in such cases. It is advisable to check the IRS guidelines concerning inherited IRA or consult a professional financial advisor for guidance.
How can you withdraw your RMD?
You can choose a one-time distribution from your RMD yearly, i.e., take out the money as an annual affair for the RMD amount year after year. However, it is advisable to set up an automatic withdrawal system from your retirement savings account to avoid the otherwise dire consequences of forgetting to take your RMD. You can opt to take your mandatory distributions via a check, or a direct transfer to your bank account, or via a brokerage or cash management account. You may also select the frequency of receiving the funds – monthly, annually, or as per your preference.
How do RMDs affect taxes?
Generally, withdrawals from your retirement accounts become a part of your taxable income unless the contributions were on an after-tax basis. The RMDs you take in a year can push your income into a higher tax bracket, further impacting the taxes you owe for Medicare and Social Security benefits.
What can you do with your RMDs?
You have multiple options for how to use your RMDs. Some of them include covering living expenses, making investments, transferring wealth, and/or making charitable contributions.
- Cover living expenses: If you plan to use RMDs for your current expenses, it is best to align yourself with a budget in retirement. Budgeting will help you estimate the living expenses, manage the cash flow, and assess if you will need RMDs to support your retirement lifestyle.
- Making new Investments: Even if you do not need RMDs to support your living expenses, you are still obligated to take RMDs out of your retirement accounts. You cannot reinvest your RMDs into a tax-advantaged account, but you can place them in taxable brokerage accounts to reinvest. If you have investments that are difficult to sell, such as inherited stocks, you can transfer them to a non-retirement account. This will serve the dual purpose of fulfilling your RMDs and staying invested in the security.
- Consider wealth transfer: You can use your RMDs to fund a loved ones’ 529 college savings account. You can leverage the five-year gift tax averaging plan to give up to $75,000 every five years. Another alternative is to convert the IRA into a Roth IRA. A Roth IRA comes with much simpler inheritance tax rules and does not have RMD rules.
- Make charitable donations: You can use your RMDs to make QCDs up to the specified limit of $100,000. This is highly beneficial for high-income earners.
Conclusion
RMDs are a mandatory withdrawal that affects your taxable income, and hence, they play a significant role in your retirement finances, While you may not be calculating the RMD yourself, the onus of the withdrawal to the specified limit and within the annual deadline of December 31st is upon you, failing which you may be subject to penalties up to 50% of the cost due.
A comprehensive and thoughtful retirement plan can help you utilize your RMDs in the best possible manner, and eventually, help you attain your financial goals too. Speak with your trusted financial advisor to know the rules and regulations around RMDs when designing your retirement plan.