Required minimum distributions (RMDs) are distributions mandated from non-Roth retirement accounts by the IRS once you reach a specified age. In a sense, this is a way for the IRS to be “paid back” for the tax break you received when originally contributing the money to the account, and for the tax-deferred growth of your investments inside of the account over the years.
RMDs apply to traditional IRA and 401(k) accounts, as well as several other workplace retirement plan accounts.
Here are the top 5 things to know about Required Minimum Distributions:
1. Starting age
Prior to January 1, 2020, the age to commence RMDs was 70 ½. The enactment of the SECURE Act raised the age to start RMDs to 72 for those who were not at least age 70 ½ prior to January 1, 2020.
For those who were taking RMDs due to having reached age 70 ½ prior to January 1, 2020, they must continue to take their RMDs as before the SECURE Act. For those who had not reached age 70 ½ prior to the beginning of 2020, their age to commence RMDs is 72.
Here is a chart to hopefully clarify this a bit.
|Age 70 ½ as of December 31, 2019||Reach age 70 ½ on or after January 1, 2020|
|RMDs continue based on your age||RMD starting age is 72|
RMDs are taxed at ordinary income rates. While the investments in your retirement accounts have likely experienced some capital gains over the years, unlike with investments held in a taxable account, there are no preferential tax rates for long-term capital gains arising from retirement account distributions.
The taxes due will flow through your tax return for the year. The amount of the income from the RMD will be added to the rest of your income from all sources for that calendar year.
In addition to the taxes due, there is a steep penalty on any RMD amounts not taken within the appropriate time frame. The penalty is 50% of the amount not taken, plus all applicable income taxes are still due. For example, if you RMD was $30,000 and it was not taken, the penalty would be $15,000.
As you can see this penalty is quite steep, so it behooves you to be sure that all RMDs are taken by the deadline for each year.
4. Calculation of RMDs and Deadlines for Taking Them
RMDs for each year are calculated based on the balance in each applicable retirement account as of the prior December 31. The calculation is based on a set of IRS tables and the factor for your age is used.
The IRA custodian or the 401(k) administrator calculates your RMD each year due to a change in the rules several years ago. They are required to report these amounts to the IRS to allow them to enforce and assess any taxes due and any penalties for RMD amounts not taken.
RMDs for each year must be taken by December 31 of that year. The exception to this rule is for first year RMDs. These distributions can be deferred until April of the following calendar year. Delaying that first RMD to the following year will result in your having to take two RMDs in the same calendar year as the second year’s RMD will still be due by the end of that calendar year as well. This would result in taxes being due on both distributions.
5. Ways to Defer or Reduce RMDs
If you are working and have reached age 72 (or age 70 ½ prior to January 1, 2020) you may not be required to take RMDs on your 401(k) with your current employer. You must not own 5% or more of the company and your employer must make an election to incorporate this option into their plan.
RMDs on the amount in this 401(k) can be deferred until you are no longer working for this company. RMDs on any other retirement accounts must be taken for that year, however.
A planning note, if your company allows for it, money in old 401(k) accounts or traditional IRAs can be rolled into your current employer’s plan if they allow these reverse rollovers. This would allow this money to be exempt from RMDs while you are working as well. You will want to be sure that the investment menu in your current 401(k) plan is solid and that the plan’s fees are low before considering this option.
Another option to consider is a Roth conversion. Converting a traditional IRA to a Roth IRA will remove the RMD requirement for the amounts converted. Note that there are taxes on the conversion amount in the year of the conversion, so you will want to review your overall situation before deciding if this is a good idea for you in a given year.
RMDs are an important and sometimes complex topic for those who are impacted by them. We hope that by highlighting these top 5 things to know about required minimum distributions we’ve answered some of your questions about RMDs.
As a fee-only financial advisor focusing on clients approaching and in retirement, we help many of our clients with planning issues surrounding their RMDs.
Please give us a call if you have any questions, we are here to help.