Most talk about retirement focuses on putting money into your account, but at some point, you will need to take that money out again. 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 are required minimum distributions (RMDs). What are RMDs and how will they impact your retirement savings?
What Are RMDs?
Required minimum distributions are mandated by the IRS and stipulate a certain amount of money be withdrawn from qualified retirement accounts on an annual basis. These rules dictate the minimum amount of money that has to be taken out of qualified retirement accounts each year.
RMDs come into effect when you turn 70 ½. The first year you take your RMDs, you can wait until April 1 of the year after you turn 70 ½, however, 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 Every subsequent distribution (including any remaining money needed to be withdrawn in the first year) must be taken by December 31.
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you don’t take enough out of your accounts, the IRS will issue a steep 50% penalty on the money that was supposed to be withdrawn.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 so as to avoid any penalties.
What Accounts Are Impacted?
All of the money that you have contributed to a tax-advantaged retirement account has been deposited on a pre-tax basis, so RMDs were put in place for the IRS to start taxing that money. Most tax-deferred accounts are subject to RMDs and include the following according to the IRS website:
- 401(k), 403(b), 457
- Traditional IRA
- SEP IRA
- SIMPLE IRA
- SARSEP IRA
- Roth 401(k)
The only account that isn’t subject to RMDs is a Roth IRA as long as the primary owner is still alive. Inherited Roth IRAs will require distributions.
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 make a big impact on your tax bill.
How To Calculate 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 who’s 401(k) you are participating in) in order 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 calculate and withdraw the RMD correctly.
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 that 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 make a donation 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. There are other rules and regulations that come along with QCDs, so if this is a strategy you want to learn more about, talk with your financial advisor.
RMDs are an important part of your retirement planning. Knowing what they are and how to make them work for you will help you create a plan for your retirement income.
Here at Retire To, 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? Give us a call, and we would love to help you!