After years of saving for retirement, there comes a time when people must begin to withdraw from their accounts, even if it is just a portion. This is known as a Required Minimum Distributions (RMD) and is a rule retirees and pre-retirees are subject to follow.
When this money should be withdrawn, along with how much must be taken out, will depend upon several factors: type of account, age, retirement account’s prior year-end fair market value, and life expectancy. Life expectancy is a formula dictated by the IRS.
To avoid costly penalties, it is important to understand the rules and strategies for managing your retirement withdrawals.
In this article, we’ll look at what RMDs are and take a deeper dive into the various factors surrounding the rules regarding RMDs and the amounts that need to be withdrawn.
What are RMDs and Why Are They Important?
RMDs are mandatory withdrawals from certain types of retirement accounts upon reaching a specific age. It is important to understand the rules surrounding RMDs because when people do not adhere to them, they will be given tax penalties. Additionally, making withdrawals helps to ensure a steady income stream throughout retirement.
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RMD Rules: Who, When, and How Much?
RMD requirements apply to various types of retirement accounts, have age requirements, and calculated amounts. Let’s take a closer look at how these RMD rules work because they directly affect your taxable income.
Who Needs to Take RMDs? Account Types and Eligibility
Once a retirement account owner reaches the required age to take RMDs, they must do so, lest they face IRS penalties. Retirement accounts requiring RMDs include:
- Traditional 401(k)s
- Self-employed 401(k)s
- 403(b)s
- 457(b)s
- Individual retirement account (traditional IRA)
- Rollover IRA
- SEP IRA
- SIMPLE IRA
- Inherited IRAs (designated beneficiary collects IRA funds after the account owner’s death)
- Inherited Roth IRA* (designated beneficiary collects after the account owner dies)
- Profit sharing
- Money purchase
*Keep in mind that RMD rules do not apply to Roth IRAs for the individual account owner, only to inherited Roth accounts since they aren’t tax-deferred accounts for the original owner.
Age Requirements for RMDs
An important rule to know is if you make withdrawals from a retirement account before you turn 59 ½, you will receive a 10% early withdrawal penalty. This isn’t advisable because it is costly.
You can choose to withdraw at age 59 ½ without penalty, but you would still be young enough where it’s not required. Many people choose not to begin withdrawing at 59 ½ to avoid increasing their taxable income.
However, once you turn 72 years old, you must begin to make withdrawals within the required distribution period for your retirement savings (the IRS provides this information). If you reach 72 after December 31, 2022, you can begin withdrawing at age 73.
Keep in mind, that these rules are always subject to change since laws continually change regarding retirement accounts. Most recently, the Setting Every Community Up for Retirement Enhancement Act of 2019 (The SECURE Act) directly affects RMDs.
Furthermore, it’s possible other laws may also be passed or further modifications of the SECURE Act occur (this law was most recently modified in December 2022).
Previously, individuals were required to take RMDs at 70 ½, but with the new change, they can delay this until age 72, and no later than 73. Keep in mind, that retirement funds taken out become taxable, so you want to strategically select the time frame you choose to begin withdrawing.
Working with an experienced financial advisor can help you determine what’s required in your situation, along with determining the best retirement savings and withdrawal strategy for you.
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How to Calculate Required Minimum Distribution (RMD)?
The Internal Revenue Service uses the Uniform Lifetime Table (ULTAB) to calculate RMDs.
For original account owners, the account’s year-end balance is divided by the current year’s life expectancy factor, which can be found on the ULTAB, to determine the required withdrawal percentage. This is based on your age and your retirement account’s fair market value.
Because your end-of-year balance and life expectancy factor change every year, your RMD will be different each year as well. However, there are some variations of this rule.
For instance, if you have a spouse who is more than 10 years younger than you, and you’ve listed your spouse as your 100% primary beneficiary for the year, this will directly affect your RMD.
The IRS, in this case, will use the IRS Joint Life Expectancy Table (see page 7 of this IRS document) instead. People with much younger spouses will find the inclusion of their ages will increase the life expectancy factor, which changes your RMD requirement.
Essentially, with a higher life expectancy factor, the IRS will permit you to withdraw less money from your retirement account.
Tax Implications of RMDs
RMDs are typically taxed as ordinary income, so this can potentially greatly impact your tax bracket. A primary effect is for people who are still working but reach the age when RMDs are required because they’ll have more income with each withdrawal, subsequently increasing their taxable income.
Fortunately, there are financial strategies you can leverage to help reduce the potential tax effects of RMDs. For instance, you may be able to utilize Roth conversions or use pre-tax dollars in retirement accounts. Using these or other strategies could help reduce tax liability and other burdens associated with RMDs.
Financial advisors can help identify tax-reducing strategies. Get Matched With a Financial Advisor Today
Planning and Timing Your RMD Withdrawals
Ideally, you want to include timing in your retirement planning strategy. Since RMDs from tax-deferred retirement accounts increase each year once you reach 73, you may need to offset some income to avoid being put in a higher tax bracket.
Bottom line, you should know your deadlines for taking RMDs each year, along with the potential consequences of missing your deadlines.
Equally, you must balance your withdrawals with all of your retirement income sources, including but not limited to pensions, Social Security, and other retirement accounts to ensure you have a sustainable income stream. **
Missing an RMD: Penalties for Non-Compliance
RMDs are put into place by the federal government to prevent people from using a retirement account to avoid paying taxes.
With the RMD requirement, U.S. taxpayers will pay taxes on their income either starting at 59 ½ should they decide to withdraw when eligible or by the time they reach 72.
Failing to take an RMD will result in non-compliance. The IRS imposes penalties for failing to take RMDs. This is subject to change, but current IRS rules dictate if an individual does not withdraw the full amount of the RMD by the due date, the taxpayer will be subject to an excise tax.
The IRS, in 2022, reduced this tax from 50% to 25% in 2022 when the SECURE Act was updated.
Other ways a taxpayer can avoid non-compliance penalties are if they can prove they didn’t adhere to the RMD rule due to “reasonable error” and that they are taking steps to fix their mistake within two years. The IRS may even lower the excise tax if adequate steps are taken.
Consulting with a financial and/or tax advisor can help establish an RMD strategy to ensure the rules are followed and timely RMD withdrawals are made.
Strategies for Managing RMDs Effectively
Fortunately, people can choose from a number of strategies to help them effectively manage RMDs to enjoy the least costly solution when it comes to income taxes.
1. Qualified Charitable Distributions (QCDs)
If giving to causes you care about is a part of your financial planning, you can make qualified charitable deductions (QCDs).
How it works is, upon reaching the age of 70 ½, you can reduce or satisfy your RMD by making a qualified charitable distribution by directly transferring money from your traditional IRA to a QCD.
RMDs are taxable, but QCDs are not. U.S. tax law allows individuals and married couples to donate up to $105,000 (this number is subject to change but is the current amount for tax year 2024).
Alternatively, you can make a one-time QCD of $53,000. To ensure you do this correctly, follow all requirements for the organization you’re donating to, and check on the most current amounts allowed to donate.
It’s a good idea to speak with an experienced tax advisor. You cannot claim this donation as a charitable deduction, but doing so can also offset your taxable income. Your advisor can help you determine if this is the right avenue to take. ***
2. Roth Conversions and Other Strategies
Converting your account to Roth IRAs is a potential way to help offset taxes associated with your retirement accounts since they are exempt from RMDs.
This works best for people who anticipate being in an upper tax bracket when they eventually begin relying upon retirement income, earn income meeting IRS requirements, and do not need their retirement accounts to financially support themselves.
For some people, it makes sense to begin withdrawals at age 59 ½ in what’s called a “proportional withdrawal strategy”. In this approach, you effectively “spread out” your tax obligations over your retirement years by selectively choosing when and where to withdraw.
There are some drawbacks to this strategy, so it’s a good idea to obtain professional advice on whether this or any other strategies make sense for you.
Why You Need a Financial Advisor to Help Your RMDs
Career trends have changed since the mid to late 20th century. According to a December 2023 report from the Pew Research Center, about 19% of adults aged 65 and older continue to work. CBS in October 2023 reported that 26% of people between 65 and 74 continue to work, but over age 75, the number “shrinks” to roughly 7%.
People are living longer, in better health, and can find less strenuous work, all of which significantly impact retirement planning. However, maintaining an income from work during the years people must begin withdrawing money from retirement plans poses some challenges.
Most people don’t have just one account, they likely have a combination of various retirement accounts, multiple IRAs, mutual funds, Social Security, pensions, and/or other sources of retirement income. They’ll need to carefully consider how they’ll approach their annual required minimum distributions.
As a result of these and other factors, account holders must strategically and proactively plan for how and when they want to retire, so they can determine the best courses of action to manage their retirement planning.
Some may want to collect their retirement savings earlier, but a growing number of people may want to delay until the IRS mandates they begin retirement withdrawals.
It’s never too soon to start planning. Use Our Free Advisor Match Tool to find the right advisor to work with to help ensure a smooth transition into retirement and maximize your retirement income.
**The information provided on this site is for informational purposes only and should not be construed as financial advice. Invested Better does not guarantee the accuracy or completeness of the information provided. Please consult with a licensed financial advisor before making any financial decisions.
***Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results.
