Required Minimum Distributions: Big and Complex, So Here’s a Guide
There’s a stiff 50% penalty if you fail to follow IRS rules on retirement accounts
Years ago when you started saving for retirement in a 401(k) or IRA, you likely weren’t focused on the deal you’d made with IRS.
The IRS gave you immediate tax breaks on what you saved. Contributions to traditional 401(k)s — and 403(b)s — reduced your taxable income, and many people who saved in a traditional IRA also were able to claim a tax deduction. As long as the money stayed in your retirement accounts, there was no tax bill. Once your turn 70 ½, time to start forking over taxes.
Even if you don’t need to use money in your retirement accounts, the IRS forces retirees to withdraw no later than the calendar year after they turn 70 ½, so it can collect taxes.
Those forced withdrawals are called required minimum distributions (RMDs): Every dollar you withdraw from a traditional retirement account is taxed as ordinary income. (There are no long-term capital gains rates.) The more you’ve saved, the bigger your RMDs will be. That can result in owing more tax than you anticipated.
Here’s what you need to know to stay in the IRS’s good graces:
RMDs must start once you turn 70 ½. If you are still working and have a 401(k) with that employer, you don’t have to take RMDs from that plan — assuming you don’t own more than 5% of the company — but you must make RMDs from all other retirement accounts.
Technically, your first RMD isn’t due until April following the calendar year you turn 70 ½. But if you wait until the following calendar year to take that first RMD, you will also owe another RMD for that calendar year. Two RMDs from the same account in one tax year could land you in a higher income tax bracket. To avoid that, you should consider paying the first RMD in the calendar year you turn 70 ½.
RMDs are based on an IRS calculation tied to your age. The brokerage where you have a retirement account will do the calculating, or you can do a web search for “RMD calculator” to find free ones.
If you fail to make your annual RMD, the IRS will impose a penalty equal to 50% of what you were supposed to withdraw.
If you have multiple IRA accounts you can add up all the balances, compute your total RMD, and make a withdrawal from just one account (or however many you want) to cover your total RMD. You can do the same aggregating if you have multiple 403(b) accounts. But no dice on multiple 401(k)s. You must take an RMD from every 401(k) account you have.
No spousal aggregating of RMDs. You each must make RMDs from your individual accounts.
Strategies for reducing your RMD tax bill
Save in Roths. If you are still working and saving for retirement, consider shifting your future contributions to a Roth 401(k) or Roth IRA.
With a Roth, your contributions are made with after-tax dollars. But because you’ve prepaid your tax, you will not have any RMDs, and money you want to withdraw will be tax free. One technical caveat: If you save in a Roth 401(k), you will have RMDs, but they won’t be taxable. Or once you leave that job, you can roll over the Roth 401(k) into a Roth IRA to avoid the RMD hassle.
The majority of large employers now offer a Roth 401(k) option. All plan participants can save in the Roth 401(k), regardless of income.
With a Roth IRA there is an income limit on direct contributions. In 2019, individuals with adjusted gross income below $122,000 and married couples with income below $193,000 can contribute $6,000 to a Roth IRA. The limit is $7,000 for anyone at least 50 years old.
Convert traditional accounts to Roth accounts before you turn 70 ½. If you retire before you are 70, or have scaled back your work in your 60s, you may be in a great position to move some money from your traditional retirement accounts into Roth accounts. Money in Roth accounts isn’t part of your RMD calculation.
You will owe tax on every dollar you “convert,” but if your income has fallen to the point that you are in a lower tax bracket, that can be a smart move. A tax pro can help you decide.
Save in a health savings account. If you have a high-deductible health insurance plan, you are eligible to save in a health savings account (HSA). Your contribution is tax deductible, the money grows without being taxed, and if you use the money to pay for medical bills there is no tax due. You can use HSA funds any time — to pay this month’s bills, or to pay bills years from now, in retirement. There is no RMD on an HSA.
Make charitable donations from your IRA. You can donate up to $100,000 a year from IRAs and have that money count as your RMD. The value of your contribution will not count as taxable income (as would a regular RMD.) This isn’t allowed with RMDs for a 401(k).