What You Should Know About Required Minimum Distributions (RMD)

Are you planning out your retirement strategy but are puzzled about required minimum distributions (RMDs) and what they mean for you? If so, the good news is you’re not alone. The bad news is that failure to set a proper RMD withdrawal strategy can result in significant tax penalties.

RMDs are annual distributions required from a tax-deferred retirement account once you reach the age of 70 ½ years old. (Note that you can take withdrawals of any amount without penalty once you reach age 59 ½.)  They are also required if you inherit an IRA or 401(k) type account at any age. Distributions are subject to income tax, since they were saved “tax-deferred” during your working years. A key component of your retirement planning is taking required minimum distributions from your retirement accounts. But there are rules that govern when you must start taking withdrawals and the minimum amount you must withdraw from specific retirement accounts. Below are some tips you should know about RMDs:

• How do I calculate my RMD?

Difficulty: The annual distribution amount that you are required to withdraw is calculated by taking your account balance at the end of the previous year and dividing it by your statistical life expectancy (IRS tables). For this, you will need to know your balance as of December 31 of the previous year, and the factor provided by the IRS.

Strategy: The IRS has Required Minimum Distribution Worksheets to help you calculate your exact withdrawal amount.

• What are the general guidelines for 401(K)s and RMDs?

Difficulty: If you are still working at age 70 ½ , you generally won’t have to begin taking withdrawals from your current employer’s 401(k) (or 403(b), TSP, 457(b) and similar accounts) until after you retire. You would, however, need to take distributions from any previous employer’s 401 (k) plans and IRAs.

Strategy: If you have multiple 401(k)s you can take the RMD from each one, but you may also take the total amount from a single account. You may also talk to your financial advisor about consolidating or rolling over your retirement funds into an IRA to make it easier to manage.

• What are the general guidelines for IRAs and RMDs?

Difficulty: With IRAs, you will need to take your first RMD by April 1 of the year after you turn 70 ½ years old.  

Strategy: If you have multiple IRA accounts, calculate the required distribution amount for each of your accounts. You can withdraw your RMD from any of your IRA accounts as long as you withdraw the cumulative total amount.

• What happens if I don’t withdraw my RMDs?

Difficulty: Unfortunately, missing your RMD deadline results in a hefty U.S. tax penalty — generally around 50 percent. This penalty is in place to ensure taxes are paid and not put off indefinitely or avoided altogether.

Strategy: According to the IRS, “The penalty may be waived if the account owner establishes that the shortfall in distributions was due to reasonable error and that reasonable steps are being taken to remedy the shortfall.” You may also choose to donate up to $100,000 per year to a 501(c)3 nonprofit. This effectively cancels out the income taxes due on the distribution against the deduction for the charitable contribution. However, the best strategy would be to work with your financial advisor to calculate your withdrawal amounts and the best timing for taking out your RMDs each year to keep you from being penalized.

• What if I inherit an IRA or 401(k) and I am under 59½?

Difficulty: Normally, if you are under 59½ you would pay a 10% penalty for an early withdrawal from your retirement accounts. However, if you are widowed and you are the beneficiary, you have the option to treat it as an inherited IRA or combining the inherited accounts into your account. Making the choice that’s best for you can be confusing. If you inherit an IRA from a non-spouse, you must take RMDs based on your life expectancy. There are also rules that require that the entire inherited account be distributed over five years.

Strategy: If you are a widow under age 59 ½, it may make sense to treat it as an inherited IRA and take RMD based on your life expectancy. Remember, the RMD is the “minimum” distribution and you can take more, but not less than that amount. Upon reaching 59 ½ you can then combine the accounts and take distributions as needed. Non-spouse beneficiaries cannot combine the inherited IRA with their other accounts, and must take the RMD by the year following the IRA owner’s death.

• Why will I need to take two RMDs withdrawals in one year?

Difficulty: The first year that you begin taking out your RMDs can be a little complicated. For instance, if you turned 70 ½ on June 20, 2017, you’ll need to take your first RMD by April 1, 2018. But that distribution actually counts for the year 2017. You will still have to take your 2018 RMD by Dec. 31, 2018.

Strategy: After your first year of taking RMDs, it’s easier in that you only need to remember to take your RMDs out every year by Dec. 31. For ease, however, it’s best to have withdrawals automated in case you forget or miss the deadline for some reason.  

What it Looks Like in Real Life

Now look at these examples.

Joan turned 70 ½ in March 2017. Her Retirement account balances totaled $500,000 at December 31, 2016. Her RMD of $18,248 for 2017 must be taken by December 31, 2017 ($500,000/27.4). If Joan’s birthday is after April 1, 2017 she can wait until April 1, 2018 to take this distribution but must take her 2018 RMD in the same year by December 31.  

Mary inherited her mother, Joan’s, IRA in 2017 and is age 63. Mary must begin taking her beneficiary RMD by the year after her mother’s death, in 2018. Assuming the balance of the IRA is $500,000 on December 31, 2017, her 2018 RMD would be $22,046 ($500,000/22.7).

The IRS has different calculations based on whether you are the IRA owner, if you have a spouse who is more than 10 years younger than you, or if you have inherited an IRA. Generally, the calculation is done automatically where your account is held. To avoid the 50% penalty for failing to take a distribution when required, many custodians will automatically calculate and pay on the basis of your choosing: monthly, annually, and transfer directly to a specified account.

Do you see why we suggest speaking with your financial advisor before making decisions on RMD?

Retirement should be the period of your life when you get to relax. Let your advisor address any questions or concerns you may have about RMDs and your retirement planning strategy. Then sit back and enjoy all the fruits of your labor.

Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.

“Finance Made Simple” blog posts are intended for educational purposes and not for specific advice. Each person’s situation is different. Consult your financial advisor for advice relating to topics discussed.