Most people spend years accumulating money in various tax-deferred retirement plans — 401(k)s, IRAs, 403(b)s, etc. Investing for retirement this way is convenient, there’s often some kind of matching contribution from your employer and these plans reduce the amount of income tax paid during your working years.
But there’s a catch that — depending on your age and the type of financial professional you’re working with — you may or may not know much about.
There will come a day when the IRS will demand its cut of the money you’ve been saving … and you can’t say no. Ready or not, when you’re 70½, you’ll have to take required minimum distributions (RMDs) from your qualified accounts and pay income tax on that money.
After 18 years in the financial industry, I’m still amazed by the lack of general knowledge about RMDs. Some people don’t even know there is such a thing. Others are misinformed about the IRS rules (which can be confusing).
Here’s a quick guide. Think of it as the ABCs of RMDs:
A is for Aggregation.
The IRS requires that you calculate the RMD for each tax-deferred retirement account, including:
- 401(k)s, 403(b)s and 457(b)s
- Traditional IRAs (but not Roth IRAs, which are funded with after-tax money and are not subject to RMDs unless the account is inherited)
- SEP and SIMPLE IRAs
- Rollover IRAs and inherited IRAs
- Keogh Plans
RMDs are based on the value of the account at the end of the prior year divided by your life expectancy factor (taken from the appropriate table in IRS Publication 590). Once you've calculated your RMD for each IRA (including traditional, SIMPLE and SEP IRAs), you can aggregate the total and withdraw your RMD from one or multiple accounts in any combination.
Your 403(b) RMDs also should be calculated separately, and the total amount can be withdrawn from any one or a combination of those accounts. Keep in mind that 403(b)s cannot be aggregated with IRAs.
An RMD from a workplace retirement account, such as a 401(k), is different. Each withdrawal must be taken from its own account.
B is for Beginning Withdrawals.
When should you take your first RMD? The year you turn 70½, you’ll be required to take distributions from all IRAs, and likely most other qualified plans, such as 401(k)s. (With 401(k)s, you can avoid RMDs from your current employer’s plan if you’re still working and you don’t own 5% or more of the company. You would, however, need to take RMDs from any previous employer’s plan.)
You need to take your RMD before Dec. 31 each year, except for the year you turn 70½. That first time only, you have the option of waiting until April 1 of the following year. This could be helpful if you’re still working and don’t want to increase your taxable income, or if the RMD could affect the taxes you’ll pay on Social Security income. Waiting, however, means you will have to take two distributions in the next year, which could bump you into a higher tax bracket.
Do the math and figure out which makes more sense for you. But don’t procrastinate and miss your payment: The penalty is a 50% excise tax on the amount you were required to take. (That’s on top of the ordinary income tax you owe on the distribution.)
C is for Consider Your Taxes.
Once you know the IRS rules and you’ve calculated the amounts you’ll likely have to withdraw from your tax-deferred accounts, it’s time to put your full focus on tax efficiency. If you’re reading this and you’re not 70 yet, there’s still time to make adjustments that could keep more money in your pocket, instead of Uncle Sam’s.
Along with strategically timing your first RMD, you may wish to begin converting some of the funds in your tax-deferred accounts to a Roth IRA. You would pay income tax on this conversion amount, but all future gains and withdrawals from the Roth would be tax free (as long as you’re age 59½ or older and have held the account for at least five years), and there would be no more RMDs to worry about.
You can spread the Roth conversion over several years or more if you start in your 60s. By converting smaller amounts each year, you are likely to stay in or around the same tax bracket without triggering a phase-out of your ability to claim personal exemptions while at the same time end up in an overall higher federal income tax bracket as well. This strategy could also make sense if your RMD is going to be significant because you might get bumped up to a higher tax bracket.
Another move with your RMDs from a tax perspective is to consider purchasing life insurance. If you are not using RMD funds for retirement income, RMD payments could be multiplied by purchasing life insurance and paid out to your beneficiaries federal income tax free. If you are in decent health, you could qualify for a significant policy by placing RMD amounts (after deducting taxes from the RMD itself) in a permanent life insurance policy. In addition, many policies have options to use the death benefit towards paying for long-term care, and distributions to cover this type of care can also have tax advantages.
Last, but not least, Congress gives you the ability to transfer your RMD to a charity without claiming it as income. You must have the funds pay directly to a qualified charity and the limit is $100,000 per year. If you are looking to support an organization or your community, this could be a strategic move to consider.
Just remember, the RMD rules are complex, the penalties for missed or miscalculated withdrawals are high and the tax implications are a minefield. One misstep could blow a hole in your retirement plan. Don’t go it alone. Talk to an experienced financial adviser and/or tax professional and weigh the pros and cons about your RMD strategy long before your first withdrawal is due.
Kim Franke-Folstad contributed to this article.
Investment advisory services offered through Global Financial Private Capital, LLC. This material is for informational purposes only. It is not intended to provide tax, accounting or legal advice or to serve as the basis for any financial decisions. Individuals are advised to consult with their own accountant and/or attorney regarding all tax, accounting and legal matters.
Isaac Wright, president of Financial Dynamics & Associates, is a financial adviser and licensed insurance professional with a focus on retirement planning and asset preservation for families and retirees. He has assisted families and retirees in reaching their financial, retirement and estate planning goals for more than 15 years. He is the author of Navigate Your Way to a Secure Retirement.
Stock Market Today: Dow Jumps 520 Points After Salesforce Earnings
The enterprise network software firm reported impressive Q3 results, sending the blue chip stock soaring.
By Karee Venema Published
Streaming May Become Less Overwhelming (and Less Expensive) Next Year
Streaming services: We’re about to enter the era of bundles, saving money in the process, study says.
By Jamie Feldman Published
Six Ways to Prepare for Widowhood and Protect the Surviving Spouse
No none wants to have to plan for losing their spouse, but having plans in place and knowing what to do when the time comes can alleviate at least some of the stress.
By Tyler Hill, Investment Adviser Representative Published
Creating a Blended Family? Three Key Steps to Consider
Blended families can make your finances and estate extra complicated, but you can head off some of those issues with careful planning.
By Adam Frank Published
Do You Need Disability Insurance?
If you work for a living, the answer is yes, so don’t overlook protecting your biggest asset. Open enrollment season is the perfect time to assess your options.
By Frank J. Legan Published
Retirement Planning in a Time of Inflation and High Interest Rates
Today’s challenges make retirement planning even more complicated than usual, but it’s not all doom and gloom.
By Ken Moraif, MBA, CFP®, CRPC® Published
Not Confident About Retirement Despite Financial Success?
You’re not alone. Uncertainty related to interest rates, government debt, long-term care and market volatility is making everyone uneasy. What can you do about it?
By Barry H. Spencer, Registered Investment Adviser Published
Risk vs Reward: Understanding This Intricate Investing Dance
The stock market can be unpredictable and complex, so having a good grasp on how to mitigate risk is essential.
By Kerim Derhalli Published
The Best and Worst Ways for Retirees to Give on Giving Tuesday
Cash donations are certainly the most convenient, but you could be overlooking significant tax advantages by taking the easy way.
By Evan T. Beach, CFP®, AWMA® Published
From Breadwinner to Retiree: How to Manage the Transition
Many people arrive at retirement with mixed emotions, including anxiety. Making the transition involves a profound shift in your mindset.
By Erin Wood, CFP®, CRPC®, FBSⓇ Published