Many people have traditional IRAs, SIMPLE IRAs, SEP IRAs, 401(k)s, 403(b)s, or other retirement accounts that provide a tax benefit during working years. When you contribute to these plans, you can defer paying taxes until you withdraw the funds in retirement. This helps save you money during working years when you probably need it the most.
Unfortunately, the IRS won’t let you avoid paying these taxes forever. You are required to take minimum distributions once you reach a certain age, and pay taxes on those distributions.
Inherited IRAs also have RMDs, however, they normally begin in the year following the death of the original account-holder. Many of the same rules and regulations apply, but the formula for their calculation is slightly different. Be sure you are using an Inherited IRA RMD calculator. (Keep in mind, some brokers call these account Beneficiary IRAs.)
In this article, we will take a closer look at these required minimum distributions, or RMDs, and some strategies to minimize the taxes that you’re paying to Uncle Sam.
What Are RMDs?
Required minimum distributions, or RMDs, are the minimum amount that you must withdraw from certain retirement accounts each year after reaching age 70 1/2.
RMDs are usually required for traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k) plans, 403(b) plans, 457(b) plans, profit-sharing plans, and other defined contribution plans.
IRAs require you to take RMDs by April 1 of the year following the calendar year in which you turned 70 1/2 years old. However, 401(k), profit-sharing, 403(b), or other defined contribution plans let you take RMDs by April 1 following the later of the calendar year you turned 70 1/2 OR retired. In other words, RMDs don’t start until after you retire in employer-sponsored retirement plans.
These withdrawals are included in your taxable income with the exception of any part that was taxed before or that can be received tax-free. For example, qualified distributions from designated Roth accounts can usually be withdrawn tax-free.
How Much Do You Need to Take?
The required minimum distribution for any given year is based on the IRS’s Uniform Lifetime Table. You can calculate the actual amount by dividing the account balance at the end of the preceding year by the distribution period from the table.
For example, suppose that you turned 80 years old and had an account balance of $150,000 last year. Your Uniform Lifetime Table Distribution Period is 18.7. Your RMD would be calculated by dividing $150,000 by 18.7 to get $8,021. You can divide the distribution period by 100 to calculate the withdrawal rate, or percentage of the account you must withdraw annually.
It’s important to note that the life expectancy factor decreases as you get older. The lower denominator in the RMD equation means that you must take out a larger portion of your retirement savings as you get older.
Inherited IRAs work a little differently:
- Spouses can treat inherited IRAs as their own; base their RMDs on their own age; base RMDs on their spouse’s age at death, reducing the distribution period of one each year; or, withdraw the entire balance by the end of the fifth year following their spouse’s death.
- Non-spouses may withdraw the entire account balance by the end of the fifth year following the account owner’s death; or, calculate the RMDs based on the Single Life Table.
What If You Forget to Take an RMD?
The most important rule to remember with required minimum distributions is to take them on time! You could pay a 50 percent excise tax if you don’t take any distributions or don’t take a large enough distribution. That’s hard-earned money going to the government, so don’t forget to take RMDs on time!
If it’s too late, you can take three steps to try and avoid the penalty:
- Immediately take the RMD that was not taken on time.
- File IRS Form 5329, saying that you made the mistake.
- Attach a letter explaining why the RMD was missed, saying that it has now been taken, and ensuring that you’ve taken steps to make sure there are no future problems.
After submitting the request, you must wait for the IRS to respond. If you didn’t pay the penalty along with the letter, you may owe interest on the penalty amount if the IRS decides that you should still be penalized. If they don’t reply in three years, you have received a waiver.
Strategies for Mitigating RMDs
The good news is that there are several ways to avoid taking required minimum distributions — or at least lessen the tax impact of taking the withdrawals.
Let’s take a look at five popular strategies:
- Start Early – If you retire prior to age 70 1/2 and your income drops, you may be able to take withdrawals from your tax-deferred account at a low income tax rate. Using these funds to meet expenses or converting to a Roth (see below) could reduce the overall tax paid on your IRAs.
- Work Later in Life – You can work past the age of 70 1/2 and not be required to take RMDs from your current employer’s 401(k). If you have other retirement accounts, you can roll them over to your employer’s account to realize these same benefits. The only catch is that you can’t own more than five percent of the company and the employer must have made the decision to allow the deferral of RMDs and rollovers.
- Convert to a Roth – You can convert traditional IRAs into a Roth IRA. While this is fully taxable the year the conversion is made, you can avoid RMD requirements in subsequent years. This makes the most sense if you have a year in which you will experience minimal taxes due to itemized deductions, tax credits, or lower income.
- Use QLACs – Qualified Longevity Annuity Contracts, or QLACs, can be purchased within an IRA or 401(k) to delay RMDs to as late as 85 years old. While these are a good idea in theory, you are limiting your future options when it comes to taking withdrawals from the account and are bound to the annuity contract’s terms, which could complicate future plans.
- Give to Charity – Qualified Charitable Deductions, or QCDs, enable anyone over 70 1/2 to donate up to $100,000 of their RMD to a qualified charitable organization. The amount given to charity is not taxable, although you cannot take a charitable contribution deduction on your taxes. It’s a great strategy if you have personal goals to donate to charity.
It’s a good idea to discuss these strategies with a financial advisor or tax professional to ensure that you have thought through every scenario. There are significant tax and planning consequences associated with each of these strategies, so a mistake could prove to be extremely costly.
The Bottom Line
Required minimum distributions are necessary for many popular retirement accounts, and they can have a significant impact on your wealth.
If you take away anything from this article, make sure that you mark your calendar and take RMDs on time. The 50 percent RMD penalty is a needless waste of money.
It’s also important to consider some popular strategies for mitigating the impact of RMDs, especially if you don’t require the amount of money that you’re withdrawing. Talk with a financial advisor or tax professional to learn more.
You should take into consideration your entire portfolio and account types to design an optimal strategy for retirement. Including taxable accounts, Social Security, and pensions can reduce the overall tax liability, boost income, or extend the longevity of your assets.
The Snider Investment Method utilizes covered calls to generate an income during retirement while minimizing the risk of selling your assets at a loss. That way, you can keep more of the portfolio’s value over the long-term and supplement your retirement with the more predictable income generated from it over time.