Unlocking the Secrets of RMDs: How to Avoid Penalties and Maximize Your Retirement Savings

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Required Minimum Distributions (RMDs) are extremely complex, but somehow the IRS still expects you to follow through with it. In this post, we’ll break it down as easily as possible, with our main goal being that you avoid any unnecessary penalties and that you know your options, no matter the type of account you have. Without further ado, let’s dive into it!

What is a Required Minimum Distribution (RMD)?

RMD stands for Required Minimum Distribution. It is a rule set by the Internal Revenue Service (IRS) that requires individuals who have reached a certain age to withdraw a minimum amount from their retirement accounts each year.

RMDs apply to traditional Individual Retirement Accounts (IRAs) and employer-sponsored retirement plans such as 401(k)s and 403(b)s. The RMD amount is calculated based on the account balance and the account holder’s life expectancy.

The age at which RMDs begin varies depending on the type of account. For traditional IRAs, RMDs must begin by April 1 of the year following the year in which the account holder reaches age 72. For 401(k)s and other employer-sponsored plans, RMDs must begin by April 1 of the year following the year in which the account holder reaches age 72 or, if later, the year in which the account holder retires.

Failing to take the required minimum distribution can result in a 50% penalty on the amount that should have been withdrawn but wasn’t.

The purpose of RMDs is to ensure that individuals use their retirement savings during their lifetime and not leave it all to their beneficiaries.

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Why wouldn’t I just leave the money in my retirement account and just withdraw what I need every month?

While it is possible to keep the money in the account and withdraw only what you need each year, it is not allowed under the IRS regulations for retirement accounts, such as traditional IRAs. RMDs are put in place to ensure that retirement savings are eventually distributed and not left to grow indefinitely.

In other words, RMDs aren’t your friend. They’re friends of the IRS because the IRS does not want you to die and have your money go untaxed to your beneficiaries. They want every last dollar from you possible, and unfortunately, it’s enforced by law.

The IRS requires that individuals begin taking distributions from their traditional IRAs at age 70 1/2 to ensure that these funds will eventually be distributed and not left in the account to grow tax-deferred indefinitely. If you do not withdraw the minimum required amount, you will be subject to a significant penalty.

It’s important to note that some other types of retirement accounts, such as Roth IRAs, do not have RMDs, so the money can be left in the account to grow tax-free for as long as you want. But for traditional IRA, the RMDs are mandatory, you can’t just keep the money in the account and take out only what you need each year.

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What accounts require you to use RMDs?

Required Minimum Distributions (RMDs) are mandatory for certain types of retirement accounts, including:

• Traditional IRAs
• SEP-IRAs
• SARSEP-IRAs
• Simple IRA plans
• 401(k)s
• 403(b)s
• Profit-sharing plans

What accounts don’t require you to use RMDs?

RMDs are not mandatory for certain types of retirement accounts, including:

• Roth IRAs
• Pensions

These accounts do not have RMDs, so the money can be left in the account to grow tax-free for as long as you want.

It’s important to note that if you inherit an IRA from someone else, you will be required to take RMDs from the inherited IRA, regardless of whether it is a traditional or Roth IRA. Beneficiary RMD rules are different than the rules for the original account owner.

Additionally, if you are still working and own less than 5% of the company that sponsors your 401(k) plan, you don’t have to take RMDs from that plan, this exception applies only to the 401(k) plan of the employer you are currently working for, not other 401(k) plans you may have.

What is the downside to using RMDs?

The main disadvantage of using Required Minimum Distributions (RMDs) is that they are considered taxable income, which can increase your overall tax liability. Additionally, taking RMDs may also limit your flexibility in managing your retirement savings, as you are required to withdraw a certain amount each year regardless of your current financial situation. This can be a problem if you need the money for other expenses or if you are in a higher tax bracket and would prefer to delay taking the distribution to a year when you are in a lower bracket. Furthermore, if you don’t need the money and you would prefer to leave it in the account to continue growing, the RMDs can be a burden.

How do I calculate withdrawals using an RMD table?

The most popularly used table for RMDs is the Uniform Lifetime Table straight from the IRS.

Here is the table to calculate RMDs for tax-deferred retirement accounts:

The distribution period in an RMD (Required Minimum Distribution) table refers to the number of years over which an individual must withdraw the minimum amount from their tax-deferred retirement account, dependent on age.

If you are 72 years old and have $1 million in your account, the RMD for the current year can be calculated by dividing your account balance by the distribution period from the IRS’s Single Life Expectancy Table.

As of 2021, and as reflected in the table above, the distribution period for a 72-year-old is 25.6, so the RMD for that year would be $39,063.28 ($1,000,000 / 25.6 = $39,063.28)

This amount must be withdrawn by December 31st of each year. It’s important to note that the distribution period will change each year and so will the RMD amount.

How does the American Rescue Plan affect IRAs with regards to RMDs?

The American Rescue Plan Act of 2021 includes a number of provisions that may affect individual retirement accounts (IRAs). One of the key provisions is the temporary suspension of required minimum distributions (RMDs) for the year 2021. This means that individuals who would normally be required to take an RMD from their traditional IRA or other qualified retirement plan in 2021 will not be required to do so. This applies to individuals who reached age 70 1/2 in 2020 or earlier and would have been required to take an RMD in 2021. That means if you were scheduled to take an RMD from your traditional IRA or other qualified retirement plan in 2021, you can just sit back and relax, no need to withdraw any money this year.

Another provision in the American Rescue Plan Act of 2021 allows individuals to make catch-up contributions to their traditional or Roth IRA for the year 2021, regardless of their age. The catch-up contribution limit is $1,000, which simply means that you can put an extra $1,000 into your account if you’d like each year as long as the plan is active.

Additionally, the American Rescue Plan Act of 2021 also includes a provision that allows individuals who received unemployment compensation in 2020 or 2021 to exclude up to $10,200 from their gross income if their adjusted gross income is less than $150,000. This exclusion applies to both traditional and Roth IRA contributions. This is like a cloak of invisibility against the IRS for a portion of your income.

It’s important to note that these provisions are temporary and may change in the future.

What are my alternatives to using an RMD?

There are a few alternatives to RMDs that may be available to some individuals:

1. Charitable donations: One option is to make a qualified charitable distribution (QCD) from your IRA. A QCD allows you to make a tax-free distribution from your IRA directly to a qualified charity, up to a certain limit. This can help to satisfy your RMD and also provide a tax benefit.
2. Roth conversions: Another option is to convert some or all of your traditional IRA assets to a Roth IRA. Roth IRAs are not subject to RMDs, so by converting to a Roth IRA, you may be able to avoid RMDs altogether.
3. Keep working: If you are still working and participating in your employer’s retirement plan, you may be able to delay taking RMDs from your 401(k) until April 1 of the year after you retire.
4. Annuitizing: You may choose to annuitize your account, which means converting your account balance into a stream of payments over your life expectancy.

It is important to note that these alternatives may not be available or suitable for everyone, and it’s best to consult with a financial advisor or tax professional to determine the best course of action for your specific situation.

Things you should know about RMDs if you have a 401(k)

1. Age: RMDs must begin by April 1 of the year following the year in which the account holder reaches age 72.
2. Calculating RMD: The RMD amount is calculated based on the account balance and the account holder’s life expectancy. The IRS provides a life expectancy table that can be used to calculate the RMD amount.
3. Taxable: RMDs are considered taxable income and must be reported on your federal income tax return.
4. Rolling over: If you don’t need the money, you can avoid paying taxes on your RMD by rolling it over into a traditional IRA or another eligible retirement plan.
5. Required from multiple accounts: If you have multiple 401(k) accounts, you must calculate and take the RMD for each account separately.
6. Beneficiary: If you are the beneficiary of a 401(k) account, you will also be subject to RMDs, but the rules are different from those for account holders.
7. Required from inherited 401(k): If you inherit a 401(k) plan, you must take required minimum distributions (RMDs) based on the life expectancy of the deceased account owner.

Things you should know about RMDs if you have an IRA

1. RMDs are mandatory for traditional IRAs once you reach age 70 1/2.
2. RMDs must begin by December 31st of the year in which the participant reaches age 70 1/2.
3. The amount of RMD is calculated by dividing the prior December 31st balance of the IRA by the life expectancy factor found in the IRS’s Single Life Expectancy Table.
4. RMDs are considered taxable income and may increase your overall tax liability.
5. You can use the money in any way you wish after receiving it, but you cannot put it back into the same IRA account from which it came.
6. If you don’t take your RMD, you will be subject to a 50% excise tax on the amount that should have been withdrawn.
7. You can use the money from your RMD to make charitable donations through a Qualified Charitable Distribution (QCD).
8. You can convert your traditional IRA to a Roth IRA, which does not have RMDs
9. Beneficiary RMD rules are different than the rules for the original account owner, beneficiaries of inherited traditional IRA accounts must take RMDs.

General FAQs on Required Minimum Distributions (RMDs)

When do I have to start taking RMDs?

The age at which you must start taking RMDs is 70 1/2, If you reach that age by December 31st of the current year, you must begin taking RMDs by April 1st of the following year. For example, if you turn 70 1/2 in January 2022, you will have to start taking your first RMD by April 1, 2023. It’s important to note that you must take your first RMD by April 1st of the year after you turn 70 1/2, but for subsequent years, you can take your RMD by December 31st of that year.

How do I calculate my RMD?

You can calculate your RMD by dividing the prior December 31st balance of your retirement account by your life expectancy factor, which is found in the IRS’s Single Life Expectancy Table. For example, if you are 72 years old and have $300,000 in your traditional IRA, your RMD would be $10,909.09 ($300,000 / 27.4). It’s important to check with your financial institution to see if they offer RMD calculation services, or if they have an online calculator that can help you calculate your RMD.

What happens if I don’t take my RMD?

If you don’t take your RMD, you will be subject to a 50% excise tax on the amount that should have been withdrawn. For example, if your RMD is $10,000 and you fail to take it, you will be subject to a $5,000 excise tax. It’s important to make sure you take your RMD on time to avoid this penalty.

Can I re-invest my RMD?

RMDs must be withdrawn in cash, you can’t reinvest them into your retirement account or roll them over into a different account. However, you can use the money in any way you wish after you have received it, you can use it to pay bills, invest in other accounts or even save it, but you cannot put it back into the same account from which it came. It’s important to plan ahead and budget for your RMDs, so you don’t find yourself in a situation where you don’t know what to do with the money.

Can I take more than my RMD?

You can take more than your RMD, but it doesn’t change the amount of your next RMD. For example, if your RMD is $10,000 and you decide to withdraw $15,000, your next RMD will still be based on the RMD calculation for the current year, not the higher amount you withdrew. It’s important to keep in mind that withdrawing more than your RMD may increase your taxes, so it’s important to consult with a tax professional before doing so.

Are there any exceptions to RMDs?

Yes, there are a few exceptions to RMDs. If you are still working and own less than 5% of the company that sponsors your 401(k) plan, you don’t have to take RMDs from that plan. Additionally, beneficiaries of inherited accounts have different RMD rules, for example, beneficiaries of inherited traditional IRA accounts must take RMDs but those of inherited Roth IRA accounts don’t have to. It’s important to consult with a financial advisor or tax professional to determine if you qualify for any exceptions.

How do RMDs affect my taxes?

RMDs are considered taxable income, so they will be subject to federal income taxes. However, if you made pre-tax contributions to a traditional IRA, a portion of your RMD may be taxed at a lower rate or not at all. For example, if you have a RMD of $10,000 and $5,000 of it is from pre-tax contributions, only $5,000 will be taxed at your marginal tax rate. It’s important to consult with a tax professional to determine how your RMD will affect your taxes and to make sure you are taking the right amount out to avoid penalties.

Can I rollover my RMD to a new account?

No, RMDs must be withdrawn in cash and cannot be rolled over into another account. However, you can use the money to contribute to a Roth IRA, as long as you meet the income limits and you are under 70 1/2.

Can I use my RMD to make charitable donations?

Yes, you can use your RMD to make charitable donations through a Qualified Charitable Distribution (QCD) which allows you to transfer up to $100,000 per year directly from your IRA to a qualified charity, avoiding taxes on the distribution. For example, if you are 72 years old and have $300,000 in your traditional IRA, your RMD would be $10,909.09 ($300,000 / 27.4), you can transfer $10,909.09 to a qualified charity through a QCD and it will not be considered taxable income.

Are there different rules for RMDs from 401(k)s and IRAs?

Yes, there are different rules for RMDs from 401(k)s and IRAs. RMDs from 401(k)s must begin by April 1st of the year following the year in which the participant reaches age 70 1/2, while RMDs from traditional IRAs must begin by December 31st of the year in which the participant reaches age 70 1/2. Additionally, RMDs from inherited 401(k)s and IRAs also have different rules.

It is important to note for all of the above that RMD rules are complex and can vary depending on your account type, age and other factors, it’s best to consult with a financial advisor or tax professional to determine the best course of action for your specific situation.

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