Most retirement planning focuses on putting money into your account, but at some point, you will need to take that money out. Distributions are an important part of your retirement income strategy, and understanding how to make them work best for you will help you optimize your financial playbook.
One type of distribution you will need to be familiar with is required minimum distributions (RMDs). What are RMDs, and how will they impact your retirement savings?
What Are RMDs?
Required minimum distributions (RMDs) are mandated by the IRS and designate a certain amount of money to be withdrawn from qualified retirement accounts annually.
Here are some other notes about RMDs:
- You can withdraw more than the minimum required amount.
- Your withdrawals will be included in your taxable income except for any part that was taxed upon placement into the account or used for a Qualified Charitable Distribution.
When Do You Have to Start Taking RMDs?
In the past, you’ve always had to begin taking withdrawals from your retirement plan account when you reached age 70½. However, changes were made by the Setting Every Community Up for Retirement Enhancement (SECURE) Act on December 20, 2019. Due to these changes, if your 70th birthday is July 1, 2019, or later, you do not have to take withdrawals until you reach age 72.
Withdrawing Your First RMD
The first year you take RMDs, you can wait until April 1 of the year after you turn 72 (or age 70½ if you were born before July 1, 1949).
Keep in mind that if you wait this long, you must take an additional distribution by year-end. Every subsequent distribution (including any remaining money needed to be withdrawn in the first year) must be taken by December 31.
For instance, a taxpayer who turns 72 in March 2022 has until April 1, 2023, to take her first RMD. But she’ll have to take her second RMD by December 31, 2023.
Taking two RMDs in one year can have significant tax implications, such as pushing you into a higher tax bracket. As a result, a larger portion of your Social Security income may be subject to taxes, or you could also end up paying more for Medicare Part B or Part D.
It’s always a good idea to consult a financial advisor first.
The Best Time to Take Your RMD
Some people like to pull their annual RMD as a lump sum while others prefer monthly or quarterly payments. But, if you delay the RMD until year-end, this gives your money more time to grow tax-deferred.
Ultimately, it’s best to choose a withdrawal that works with your retirement lifestyle and meets your needs. And no matter how you withdraw your RMD, be sure to take out the total amount before the deadline.
Should you forget to take your RMDs, or if you don’t take enough out of your accounts, the IRS will issue a steep 50% penalty on the money that was supposed to be withdrawn. RMDs are something that you need to keep track of and implement into your tax planning strategy to avoid these penalties.
What Accounts Are Impacted By RMDs?
All the money you have contributed to a tax-advantaged retirement account has been deposited pre-tax. RMDs were put in place for the IRS to start taxing that money so it cannot grow tax-free indefinitely.
Most tax-deferred accounts are subject to RMDs and include the following, according to the IRS:
- Traditional IRAs
- SEP IRAs (Simplified Employee Pension Plans)
- SIMPLE IRAs
- 401(k) plans
- 403(b) plans (Tax-Sheltered Annuity Plans)
- 457(b) plans (Deferred Compensation Plans)
- Profit sharing plans
- Other defined contribution plans
- Roth 401(k) plans require an RMD, unlike a Roth IRA.
The only account not subject to RMDs is a Roth IRA as long as the primary owner is still alive. Inherited Roth IRAs will require distributions.
You also don’t have to take RMDs from a health savings account (HSA).
How Are RMDs Taxed?
RMDs are taxed as ordinary income. The money you take out will be taxed at your regular income rate, which is why implementing tax planning strategies for retirement savings can significantly impact your tax bill.
A 2022 IRS Change is Making RMDs Smaller
The way that RMDs are calculated has changed. And that could be good news for you! Here’s why.
The Uniform Lifetime Table and its associated distribution periods come from calculations based on projected life expectancies. Previously, the table used life expectancy data from 2012.
However, the IRS updated the table in 2020 (prior to COVID-19) with assumptions of longer life expectancies. This new change became effective as of January 1, 2022.
Why It Matters
How does this impact you? Longer life expectancies equal longer distribution periods.
This is good news since lower RMDs could reduce your taxable income and thereby keep more of your retirement money for longer (and allow it to keep growing over time).
Whom Does the Changes Affect?
Don’t worry; even if you started taking RMDs well before 2021, your future RMDs would still be calculated using the new table.
How To Calculate RMDs
While the RMD calculation process may seem mysterious initially, the methodology is relatively simple. Your yearly RMD is calculated through a formula that utilizes the IRS’ Uniform Lifetime Table. This table estimates the maximum number of distribution periods (or years) your retirement account may need to take RMDs.
RMDs aren’t always easy to calculate, but the IRS does provide worksheets to help you figure it out. The primary way to determine the amount of your RMD is to take the balance of the account on December 31 of the prior year and divide that number by your life expectancy factor found in the life expectancy tables in Publication 590-B.
There are different methods for calculating your RMD depending on whether you use the uniform-lifetime, joint-and-survivor, or single-life expectancy table.
Remember, if you hold both a 401(k) and a Traditional IRA, you will need to take your RMDs by December 31 from each account (unless you are still working for the company whose 401(k) you are participating in) to avoid the 50% penalty.
Aggregation rules allow some, but not all, tax-deferred accounts to be aggregated together for RMD calculation and distribution. Be sure to take the time to work with your financial advisor to calculate and withdraw the RMD correctly.
RMD Calculation Comparison
How do 2022 RMDs compare to previous years? Let’s look at an example.
Using the New Uniform Lifetime Table: Say your IRA was worth $1,000,000 at the end of the previous year. If you’re turning 72, the new IRS distribution period for 72-year-olds is 27.4 years. To calculate your RMD, take your retirement account and divide it by the distribution period.
$1,000,000 divided by 27.4 years = $36,496
Using the Previous Uniform Lifetime Table: Keeping the IRA amount the same, $1,000,000, let’s calculate your RMD had you taken it out before the new 2022 changes. The previous IRS distribution period for 72-year-olds was 25.6 years.
$1,000,000 divided by 25.6 years = $39,062
That’s a difference of $2,566!
This extra $2,566 can be kept in your IRA to continue growing while reducing your taxable income. If you need this to help pay bills, don’t worry! You can always withdraw more than your minimum requirement at no penalty.
What To Do With Your RMDs
Most retirees rely on their RMDs for various living expenses such as housing, food, and entertainment. Should you be in a place where you don’t rely on your RMDs for your regular retirement expenses, you can donate your RMDs to charity.
Donating your RMDs to charity is a tax-efficient strategy that will help you in your tax planning while providing the charity with more money. In a process called a qualified charitable distribution (QCD), you can donate to a qualifying charity right from your IRA.
When you make a QCD, you will not have to pay income tax on the withdrawn money, which could help keep you below a certain income threshold. For the process to work, the IRA custodian must transfer the funds directly from the IRA to the charity of your choice. Should you withdraw the money yourself, you will need to pay taxes on it.
Some other rules and regulations come along with QCDs, so if this is a strategy you want to learn more about, talk with your financial advisor.
We’re Here to Help
RMDs are a vital part of your retirement planning. Knowing what they are and how to make them work for you will help you create a sustainable and dependable plan for your retirement income.
At Goepper Burkhardt Wealth Management, it is our goal that you live the retirement of your dreams. Are you ready to start creating your retirement income strategy, or does your existing plan need a refresh?
Reach out to us anytime, and we would love to help you!
Updated December 1, 2022.