As you approach age 72, it’s time to start thinking about taking required minimum distributions (RMDs) from retirement accounts such as 401(k)s, 403(b)s, and individual retirement accounts (IRAs). There are many rules and requirements to be aware of regarding these mandatory withdrawals – not including the tax ramifications.
To avoid costly mistakes, such as withdrawing the wrong amount or forgetting to take distributions altogether, it’s a good idea to create a long-term plan that outlines your retirement distribution schedule.
What is the minimum distribution required?
RMDs are required annual withdrawals from a retirement account such as an IRA or 401(k). It is the minimum amount that must be withdrawn after reaching a certain age to comply with federal tax laws.
“After you turn 72, the IRS requires you to distribute some of your retirement savings each year from qualified retirement accounts like 401(k), 403(b), and most IRAs,” says Sri Reddy, senior vice president of retirement. solution for Principal Financial Group. “However, there are certain exceptions that can be delayed – if someone is still working at age 72, and he does not own more than 5% of the business, he can wait to start RMDs until April 1, after the year of retirement. .”
Roth IRAs, which are funded with after-tax money, represent another exception to the distribution rule. There are no required minimum distributions with these accounts, meaning that money can be left in the IRA by the original owner for life if desired.
For other retirement savings accounts, required minimum distributions must be taken at retirement, whether you need the money or not.
“Taking RMDs is a routine task for many retirees, but there are certain situations where you need to put more thought into your options,” says Melissa Shaw, wealth management advisor for TIAA.
Errors to be made with the minimum required distribution
1. Delay the first RMD
In general, you must take RMDs by December 31st of each year. However, for the first year after you turn 72 and retire, you have until April 1 of the following year to take your initial distribution.
But if you benefit from a longer deadline, you must take two distributions within a 12-month period. This is because you still have to take your next annual minimum distribution by December 31st of that year.
Taking two RMDs in one year can affect your annual income because the distributions are taxed as ordinary income. Too much income in one year from your retirement account can put you in a higher tax bracket.
2. Forget to take your RMD
Another common mistake is forgetting to take your RMD. The IRS imposes a 50% penalty on your RMD amount if you don’t take it by the annual deadline.
“It’s a punishable offense,” Shaw said. “Most financial institutions give you the option to set up automatic RMD withdrawals each year. These withdrawals can be set up as monthly distributions if you need to change your income, semi-annual distributions, quarterly distributions, or annual distributions. Automating your RMD withdrawals is a great way to ensure that it will be done, even if you forget.
3. Mix plan types to meet RMDs
For those with multiple types of retirement accounts, it’s important to understand the rules regarding annual distributions for each individual account. Most importantly, you are not allowed to use multiple withdrawals type retirement accounts – such as IRAs and 401(k) – to meet the annual RMD threshold for one from that account.
For example, you cannot take withdrawals from a traditional IRA and Your 401(k) is the only RMD requirement for a traditional IRA. On the other hand, if you have multiple retirement accounts of the same type—such as multiple traditional IRAs—you can use withdrawals in those accounts to meet the annual RMD for one.
“If a person has more than one traditional IRA account, they can take the total IRA RMD from one of the IRAs or a combination of them,” explains Reddy.
It also makes a difference to know about the work plans you have with past employers you may have worked with throughout your career. Here, too, there are certain nuances that must be taken care of.
“For those who have an employer-sponsored pension plan from their former employer, the RMD should be taken directly from the plan. If they have more than one pension plan, they should take the RMD from each plan separately, without allowing consolidation,” added Reddy.
4. Combine RMDs with your spouse
While there are many financial benefits to consider as part of a marriage, retirement accounts should be held individually. They are not joint assets. And that fact affects how RMDs are handled. Often, spouses assume they can take all required annual distributions from one spouse’s account. But that is not the case.
“This will be viewed as a missed distribution for the non-withdrawal spouse, triggering the 50% tax guideline on the distribution,” Reddy said. “Also, a larger distribution from a withdrawing spouse can have some tax implications, including the possibility of pushing it [annual income] to different income groups.”
5. Cancel the wrong amount
Finally, it is important to calculate your RMD correctly. Withdrawing less than your RMD, for example, can result in a tax penalty of up to 50% of the amount you need to withdraw. There are RMD calculators available online that can help sort through the complicated task of determining the correct withdrawal amount.
Most importantly, you must calculate your annual RMD using your account balance as of December 31 of the previous year. But that’s not the only consideration.
“RMDs are calculated by dividing the December 31 balance of each account by life expectancy, as estimated by the IRS life expectancy table,” explains Reddy. “As retirees age and life expectancy decreases, RMDs will increase. At age 90, for example, withdrawals amount to almost 10% of the account value.
The IRS provides a worksheet to help with these calculations. Additionally, many financial institutions calculate RMDs for plan participants. However, the account holder is still responsible for withdrawing the correct amount.
Make a long-term plan for minimum required distributions
One of the best ways to keep track of your RMDs and manage the tax bill associated with your withdrawals is to develop a long-term plan that maps out your distributions. This is especially important if you have multiple retirement accounts that you will be juggling.
Talking to a financial advisor can be helpful when developing this type of plan.
“When considering a long-term plan, it’s important to consider your basic needs, potential health care costs, and the lifestyle you want to live in retirement,” says Reddy. “This will help you understand your drawdown plan when you take RMDs each year. These considerations should be taken into account for the five years or more until your proposed retirement.
Takeaway
Required minimum distributions can have a significant impact on your retirement income. If you miss the withdrawal deadline or withdraw the wrong amount, it can have costly consequences, including a 50% tax penalty on your RMD and bumping you into a higher tax bracket for the year. Knowing the rules and regulations on how you meet your annual RMD from different types of retirement accounts is also critical.
Creating a long-term plan that outlines how your RMDs will be handled and when they will be taken can help you avoid costly mistakes.