Managing your Required Minimum Distributions (RMDs) in Retirement
By Scott Snider
KEY TAKEAWAYS:
A Required Minimum Distribution (RMD) is the minimum amount of dollars that an owner of an IRA, 401(k) plan, 403(b) plan, 457(b) plan, or profit-sharing plan must take out annually.
RMDs are calculated by taking the account balance from the previous calendar year and dividing it by the applicable divisor – AB / AD = RMD.
It is critical to stay on top of your RMDs year-to-year because when an RMD gets missed the year it was supposed to be taken, you may incur a tax penalty of 25%.
Qualified Charitable Distributions (QCDs) offer a way to reduce your tax burden when faced with unwanted RMDs.
This article aims to provide the framework needed to understand how to take control of your RMDs throughout your retirement by teaching you what they are and how to calculate them. To tie everything together, we will illustrate why anticipating your RMDs can help you avoid the costliest mistakes, and then we will demonstrate how you can optimize your taxes with a little-known technique.
Understanding RMDs
A Required Minimum Distribution (RMD) is the minimum amount of money that a retirement plan account owner (401(k) or 403(b) plan) or traditional IRA owner must withdraw annually starting in the year they reach 73. Of note, this age requirement has become more generous, as it used to be 70 ½ as recently as 2020. What’s more, is that this age requirement will go to 75 starting in 2033.
The reason why mandatory distributions exist is the tax code set forth by Congress has allowed you to avoid paying taxes on that sum of money for an extended period; therefore, this is the government’s method of no longer subsidizing your ability to tax defer your nest egg. Instead, you must take out what starts as a small percentage of your account balance each year, and gradually that requirement grows into a larger percentage during your advanced years.
Important RMD Rules
The best way to stay current with the IRS’ minimum withdrawal guidelines is by referring to their life expectancy tables published in IRS Publication 590. Now that the “fun” IRS guidelines are out of the way… there is an exception to the age 73 minimum distribution requirement, which can occur when the retirement plan account owner is still employed and owns a 401(k) or 403(b) with that organization. Under such circumstances, that person may defer their RMD until the year they retire. Retirement plan participants should check with their employers to determine whether they qualify for this deferral.
Another important nuance to note is that the timing of your first RMD can be delayed a calendar year. That is because account holders are permitted to withdraw from their retirement account by April 1st of the following year when they reach age 73. However, if the account owner chooses to delay their first RMD to April 1st, they must take two RMDs during that calendar year.
For those of you who own Roth IRAs, those accounts are not subject to RMDs. This particular rule is why Roth conversions are a popular strategy, especially during years when your income might be lower than usual. However, Roth 401(k) and Roth 403(b) plans DO require annual minimum withdrawals. If you don’t want to be subject to such requirements, it will behoove you to rollover those funds to a Roth IRA.
Unfortunately, employer-sponsored retirement accounts are not included when allowing the aggregation of mandatory distributions, and each RMD must come out separately. On the other hand, IRAs are permitted to be combined for the purpose of taking the entire RMD amount from one IRA. For example, if you owned 3 IRAs totaling $1M and your RMD is $38,000, the entire $38,000 doesn’t have to be spread out proportionately across all three IRAs and can be taken from just one account.
The other issue with 401(k) plans is if you have multiple accounts scattered, it can be painful to manage as your mental capacity diminishes. One way to get ahead of this problem is to streamline everything by rolling over those accounts to an IRA. Otherwise, consider consolidating your other retirement plans to your current employer 401(k) plan (be sure to check if your employer plan allows rollover contributions).
How to Calculate
To begin, you will need to gather your ending account balance from the prior year. From there, refer to the IRS Uniform Lifetime Table III and use the corresponding life expectancy factor with your age in that calendar year. Using those two figures, you divide the prior year’s account balance by the IRS life expectancy factor to arrive at your RMD amount for the year. In other words, the equation is AB / AD = RMD, where:
AB = account balance at the end of the preceding calendar year
AD = applicable divisor (from Appendix C, Publication 590)
RMD = Required minimum distribution for the current year
Let’s look at an example to understand better how an RMD is calculated:
Bob Jones turns 74 in the year 2023, and his IRA had a year-end balance of $800,000. When we reference the chart below, we see that the applicable divisor is 25.5. Therefore, Bob’s RMD is $31,372.55 – calculated by taking $800,000 / 25.5.
When it is Important to Anticipate RMDs
A common misconception is that IRA custodians (e.g., Fidelity, Vanguard) and plan sponsors automatically process your RMD when, in fact, the onus is on the account holder to initiate the required minimum distribution. This ongoing responsibility to take RMDs on an annual basis is imperative to stay on top of because you will incur a tax penalty of 25% if you miss taking it. The IRS penalty is calculated by taking the difference between the required and actual withdrawals, in addition to the income tax that is due.
Anticipating your RMDs is critical to consider as part of your overall retirement income plan and how that plays into paying income taxes. Planning is especially vital when you have a large amount of IRA dollars saved. Retirees with higher balance accounts can benefit from planning because their RMD could cause them to jump into a higher tax bracket. One way to lessen the tax impacts later in life is to consider Roth conversions. When evaluating such a strategy, some tradeoffs need to be considered, which you can learn about in our other article, Roth Conversions – When It Makes Sense and When It Does Not.
Technique for RMDs
If you are charitably inclined or enjoy paying less taxes then Qualified Charitable Distributions (QCDs) are a tax savings technique worthy of further consideration. QCDs allow the IRA account holder to donate up to $100,000 per year from their IRA to qualified charitable organizations of their choosing. In order to qualify, the charity must be an approved organization under Publication 526 of the IRS code, the account holder must be age 70 ½ or older, and the donation needs to go directly from the IRA to the charity.
The primary benefit is that the amount you donate can be included as part of your RMD while simultaneously reducing your taxable income. That’s because QCDs are considered tax-free withdrawals. Let’s use Bob Jones as another example:
Bob and his wife, Cindy, tithe $20,000/year to their church but have always made those payments from their checking account. Bob just turned 73, and his first RMD is $32,000; however, he doesn’t need the money from his IRA. Rather than make their donations from their checking account, Bob and Cindy are better off if Bob directs $20,000 from his IRA to his church. In doing so, Bob reduces his taxable income by $20,000.
In conclusion, while itemizing charitable gifts is a nice tax deduction, the more significant benefit occurs when that amount is repurposed as a QCD. Tax-free is always greater than tax deductible.
RMDs – The Main Takeaway
Whenever confronted with complex information it helps to distill it down into one simple lesson. To that end, the key takeaway from this article is that RMDs are a component of your retirement income plan that demands ongoing planning and attention. Failing to keep up with the rules and regulations can lead to an expensive mistake equal to 25% of the amount that should have been distributed. The more IRA and 401(k) accounts you manage, the more challenging they are to keep up with during the later years of life. If you prefer to delegate that responsibility, let us show you how we can help.
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