Required Minimum Distributions (RMDs) can be a confusing topic for some people. It is important to understand the RMD rules and how they affect you if you have retirement accounts such as traditional IRAs, SEP IRAs, SIMPLE IRAs, and 401(k)s.
What are Required Minimum Distributions (RMDs)?
A Required Minimum Distribution (RMD) is the minimum amount of money that must be withdrawn from your retirement account each year once you reach age 72 (or age 70½ if you turned 70½ before January 1, 2020). The purpose of RMDs is to ensure that individuals do not use tax-deferred retirement accounts as a way to avoid paying taxes indefinitely.
Which Retirement Accounts Require RMDs?
Traditional IRA: You must take an RMD from a traditional IRA each year starting at age 72. If you turned 70½ before January 1, 2020, then you should start taking RMDs in the year after turning that age.
SEP IRA: If you have an employer-sponsored Simplified Employee Pension plan or SEP IRA, then you must take an RMD when reaching age 72.
SIMPLE IRA: For those with Savings Incentive Match Plan for Employees or SIMPLE IRA plans from their employers who continue working past the required beginning date of receiving distributions and thus participate in their plan are subject to begin taking distributions by April 1st following the calendar year in which they turn age 72(2).
401(k): Individuals aged over Seventy Two years old who still work can delay minimum distribution until April following the calendar year they retire. However this does not apply where one owns more than five percent interest in their company(5).
How Are RMD Amounts Calculated?
The IRS calculates your annual Required Minimum Distribution based on your life expectancy and account balance. To calculate your RMD amount:
– Determine the balance of your account as of December 31st of the previous year.
– Refer to an IRS RMD chart to determine your life expectancy factor. This is based on your age and marital status.
– Divide your account balance by the life expectancy factor.
For example, if you are 75 years old and have a traditional IRA with a balance of $500,000 as of December 31st last year, then you would divide that amount by your life expectancy factor (22.9). Your RMD for this year would be $21,834.06.
What Happens If You Don’t Take Your RMD?
Failing to take an RMD or not taking enough can result in hefty penalties from the IRS. The penalty for failing to take an RMD is equal to 50% of the amount that should have been withdrawn but wasn’t taken out.
For example, if your Required Minimum Distribution was calculated at $10,000 and you only withdrew $5,000 or failed to withdraw anything at all, then you could face a penalty of $2,500 ($5,000 x .50) or $5,000 ($10,000 x .50), respectively.
How Do You Take Your RMD?
You can choose how frequently you’d like to receive distributions throughout the year such as quarterly or yearly installments; however it’s important that total distribution adds up to what’s required under law(3).
You must take out funds from each applicable retirement account separately; however they may be combined before distribution so long as they’re subjecting taxation similarly(4).
Roth IRAs do not require minimum distributions because taxes were paid upfront instead being deferred until withdrawal unlike other tax-deferred accounts.. It’s important though for those inheriting Roth IRAs after owner’s death since beneficiaries should follow different rules regarding required minimum distributions both when distributing money during their lifetime and thereafter(1).
When Should You Start Planning for RMDs?
It’s best to start thinking about Required Minimum Distributions well before you reach age 72. By planning ahead, you can take advantage of tax-savings opportunities and maximize your retirement income.
One strategy is to consider converting some of your traditional IRA funds into a Roth IRA. This can help reduce the amount of future RMDs required since distributions from Roth IRAs are not subject to RMD rules. However, this comes with a cost as converted amount from traditional IRA will be taxed at the time of conversion(6).
Conclusion
Required Minimum Distributions play an important role in ensuring that individuals do not use tax-deferred retirement accounts such as Traditional IRAs, SEP IRAs, SIMPLE IRAs and 401(k)s indefinitely without paying taxes on them. It is essential to understand how these rules work so that you can plan accordingly and avoid hefty IRS penalties for failing to take out minimum distributions.
By taking the time now to educate yourself on Required Minimum Distribution rules and planning ahead, you’ll be setting yourself up for financial success in retirement years down the line.
References:
1. https://www.investopedia.com/roth-ira-inherited-minimum-distributions-rules-5074938
2. https://www.thebalance.com/simple-ira-rmd-rules-age-limitations-and-penalties-2388927
3. https://www.kiplinger.com/article/retirement/t045-c000-s001-how-to-take-your-required-minimum-distribution.html
4. https://www.schwab.com/resource-center/insights/content/how-to-take-your-required-minimum-distribution
5.https://finance.zacks.com/can-still-working-not-take-required-minimum-distributions-after-old-70-half-retired-8590.html
6.https://www.bankrate.com/investing/roth-ira-conversion-vs-paying-required-minimum-distributions/#:~:text=One%20way%20to%20reduce%20required,from%20the%20traditional%20IRA’s%20earnings.