By Phil West, WCI Contributor
Retirement accounts are designed to prepare people for the future, and for most of our lives, we think about what we’re putting into those retirement accounts during our working years. But there will come a time when you actually have to pull money out of those accounts during your retirement years. How much will you need to take? Part of the conversation concerns what’s called an RMD, which stands for Required Minimum Distribution.
As much as you might like, you can’t keep money in a retirement account—at least a tax-deferred retirement account—forever. Here are some of the basics governing RMDs.
What Is an RMD?
According to the IRS, an RMD is simply “the minimum amount you must withdraw from your account each year.” Of course, while you can take out more than the minimum required amount, the site notes, “Your withdrawals will be included in your taxable income except for any part that was taxed before (your basis) or that can be received tax-free (such as qualified distributions from designated Roth accounts).”
The IRS also notes that traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k) plans, 403(b) plans, 457(b) plans, profit-sharing plans, other defined contribution plans, and all inherited retirement accounts (including Roth accounts) all require RMDs.
To calculate it, you take “the account balance as of the end of the immediately preceding calendar year divided by a distribution period from the IRS’s Uniform Lifetime Table.” If the sole beneficiary is the owner’s spouse and that person is 10 or more years younger than the owner, you would use a different table.
The table includes a “life expectancy factor” that decreases with each year and actually increases the RMD. So, for example, if you have $500,000 in an account and you turn 74 that year, the divisor is 25.5 and you’d have to take out a minimum of $19,607. But if you have that same $500,000 and you’re turning 80, the divisor is 20.2 and you’d have to take out at least $24,752.47.
If you have more than one retirement account, you can choose to take your RMD from one or more of those accounts, provided the total adds up to all your RMD values.
More information here:
Understanding Required Minimum Distributions
At What Age Do You Have to Take an RMD?
This is a bit of a moving target thanks to some new legislation that was passed in December 2022. The Secure Act 2.0 made some significant changes to retirement accounts. As we noted in February:
“The RMD age is going up. It has been 72 since the original Secure Act passed. Now, it's going to be 73 starting in 2023. If this is your year that you were going to have to start doing RMDs, you get one more year reprieve and then it's going to go to 75 starting in 2033. For those of you in your 40s like me, you're not going to have to take RMDs until you're 75. Obviously, you still can and you can take that money out at any time starting at 59 1/2, but you don't have to start taking any money out until 75. That's another 15 1/2 years of tax-protected compounding that you can enjoy beyond age 59 1/2.”
The easiest way to think about this is if you were born between 1951 and 1959, you start your RMDs at age 73. If you’re a child of the ‘60s—born 1960 or later—you’ll start at age 75. Unless, of course, there’s another legislative change down the road.
Why Do You Have to Take an RMD?
Simply put, retirement accounts are designed to help people pay for things after they stop working, and a number of retirement accounts allow you to stash money without it being taxed. Therefore, incentives are put in place through the RMD system so you use that money over time when you’re living but not working.
And if you don’t withdraw the money when you’re supposed to, it can cost you. As US News pointed out:
“Account holders who do not take a RMD at the correct time typically face penalties. Before the Secure 2.0 Act, the tax penalty was 50% on the required amount that was not withdrawn. If an individual failed to take an RMD of $2,000, they would need to pay a 50% tax penalty, or $1,000. The Secure 2.0 Act changes this penalty to 25%. In the case of a missed RMD of $2,000, the charge would be $500.”
It is possible, though, to get the IRS to lower the penalty to 10% or to waive it altogether by admitting that you made an error and quickly resolving the issue.
You don't have to actually spend your RMD. You just have to take the money out of the account and pay the taxes on it. At that point, you can do whatever you want with it: spend it, give it away, or reinvest it in a taxable account. Also, bear in mind, if you are a high-income professional, you likely saved 32%-37% when you put that money into your tax-deferred retirement account during your working years, and you are likely pulling it out at rates of 0%-24% after your retirement. Saving at 37% and paying at an effective rate of 15% is a winning combination, even if the tax bill is larger on an absolute basis due to a few decades of compounding.
More information here:
Which Investments Don't Require an RMD?
Roth IRAs are the main retirement investment vehicle that doesn't require an RMD—but really since Secure Act 2.0 passed, for any investment in which you’re paying tax now, you don’t have to worry about RMDs. If you’re concerned about RMDs constraining you when you reach retirement age, it is possible to do a Roth conversion. That strategy might be to your advantage, taking money out of an investment that forces you to pay RMDs and putting it into an investment that doesn't.
As we've previously written:
“A Roth conversion is basically taking tax-deferred money and taxable money and moving them together into a tax-free account. So, you might take $50,000 of tax-deferred money and convert it to a Roth and pay $20,000 in taxes . . . Now, there are no more RMDs. If you recognize this is a problem you'll have, you can even do Roth 401(k) contributions as you go along and then move that money into a Roth IRA before age 72.
This solution allows your money to continue to grow in a tax-protected manner, eliminates RMDs, provides even more asset protection than you had previously (because some of the money was in taxable), facilitates estate planning through the use of beneficiaries, and allows the use of a Stretch Roth IRA.”
Also, if you have a charity you plan to contribute to annually in retirement, you can use a retirement account to do what you might normally do from your checking account. Another route you could go is to give tax-deferred money to charities instead of cash—a Qualified Charitable Distribution, which comes from your qualifying account directly to a charity. While you won't get the usual tax deduction, you won't have to pay taxes on the charitable contribution and won't have to take an RMD, so that's really the same thing.
If you’re contemplating these questions, it’s a good sign. Investing in retirement funds now will bring you peace of mind later . . . just know that eventually, the money you set aside for retirement will need to come out and facilitate that retirement. The more you consider what’s best for you now—whether that’s a Roth conversion or letting your investment grow in any number of investment vehicles requiring RMDs—the more you can be ready when you reach that age and the better off you'll be.
If you need extra help with planning for retirement or have
questions about the best way to save your money in tax-protected accounts, hire a WCI-vetted professional to help you figure it out.
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