5 Costly RMD Mistakes That Will Put a Dent in Your Savings (and How Early Planning Can Help)
Like your golden years, RMDs creep up on you quicker than you think. Planning ahead can help make sure you (and your heirs) don't get hit with penalties and extra taxes.
For retirees and those closing in on retirement, understanding how to manage required minimum distributions (RMDs) is essential.
These government-mandated withdrawals must be taken from tax-deferred retirement accounts, such as traditional IRAs and 401(k)s, starting at age 73. Yet, as a longtime financial adviser, I've learned that many investors nearing that age aren't familiar with how RMDs work or prepared to deal with the extra taxes they can trigger.
Even those who know something about RMDs aren't always aware of recent rule changes or useful strategies that might help reduce their RMD tax burden. That means they could easily make costly missteps that impact their retirement savings.
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What are RMDs?
The IRS doesn't allow retirement savers to keep money stashed in their tax-deferred accounts indefinitely. Once you turn 73, you must begin withdrawing a minimum amount annually (based on an IRS formula) and pay ordinary income taxes on that amount.
These mandated withdrawals are called required minimum distributions. And failing to take the appropriate distribution at the correct time can result in a hefty penalty.
The RMD rules apply to all tax-advantaged plans except Roth IRAs because those account owners have already paid taxes on their contributions.
Common mistakes with RMDs
1. Taking RMDs without advance tax planning
RMDs start at age 73 for most people born between 1951 and 1959. And those born in 1960 or later will start at age 75. But I recommend planning for these complicated withdrawals long before you're required to take them.
When you hear retirees complain about paying much more in taxes than they expected in any given year, it's often because they weren't ready for how RMDs would affect their taxable income.
For example, your RMD could push your income past the IRS threshold that determines whether your Social Security benefit will become taxable and at what percentage it could be taxed.
Your withdrawal could also trigger the income-related monthly adjustment amount (IRMAA), a surcharge on your Medicare premiums. Planning ahead could help you avoid these and other RMD-related tax traps.
2. Waiting until the last minute to take your first RMD
RMDs generally must be completed by December 31 of the current calendar year. In the year you turn 73, however, you'll have the option to delay taking your RMD until April 1 of the following year. (For example, if you're turning 73 in 2027, you'll have until April 1, 2028, to take your first RMD.)
But there can be consequences for postponing. If you decide to make two withdrawals in one year, your taxable income will likely be higher for that year, which could mean facing a steeper tax bill. Before you decide to double up, you may want to run the numbers to be sure it makes sense.
In fact, waiting until the last minute in any year could cause problems if you suddenly get busy, can't afford or simply forget to take your RMD.
If you haven't withdrawn the full RMD amount by the deadline, you could face a 25% penalty on the amount you haven't withdrawn. (That drops to 10% if the RMD is corrected within two years.)
If you decide to wait until the RMD deadline, you also may have to sell investments in a down market. Spreading out your withdrawals could help reduce market risk.
3. Forgetting inherited IRA rules
Planning to leave what's left in your accounts to your beneficiaries? They, too, will have to take distributions based on IRS rules. And they, too, could face a penalty if they don't correctly calculate and take their required withdrawals at the proper time.
The rules for when account beneficiaries must take RMDs vary based on the inheritor's relationship to the original account holder. A spouse who inherits a retirement account usually has more flexibility, for instance, when it comes to determining how soon RMDs will begin and how they'll be calculated.
But most non-spouse beneficiaries are required to empty their inherited account and pay taxes on this income within 10 years of the original account holder's death. Which means adult children often end up having to take RMDs from an inherited account during their highest-earning years.
If you expect to leave money in a 401(k) or similar account to your loved ones, it's important that they have a chance to do their own tax planning. Your financial adviser should be able to suggest strategies to help them maximize your generous gift.
4. Missing out on qualified charitable distribution opportunities
It may be difficult to predict exactly how much your RMDs will be from year to year — or how much they might impact your taxes. But just knowing they're coming will give you an opportunity to prepare.
If charitable giving is part of your financial plan, a qualified charitable distribution (QCD) can help you further your philanthropic goals and reduce the tax hit from your RMDs.
QCDs allow individuals age 70½ and older to make tax-free donations directly from an IRA to a qualified charity, potentially satisfying all or part of the annual RMD amount due from their eligible accounts.
A QCD doesn't offer a tax deduction, but the amount of your QCD won't be included in your taxable income. And you can make a QCD from several different types of tax-deferred retirement accounts — although there are rules regarding using a SIMPLE or SEP IRA, and you can't make a charitable contribution from a workplace retirement plan, such as a 401(k).
5. Ignoring Roth conversion strategies before RMD age
Converting a traditional IRA to a Roth IRA can help you avoid RMDs altogether — or at least lower the amount you'll have to withdraw each year.
Unlike traditional IRAs, Roth IRAs don't require that you take RMDs during your lifetime. This means you can keep your money invested for as long as you want, allowing it to grow tax-free. And if you pass on a Roth IRA to your heirs, they can take their RMDs tax-free.
Of course, you'll have to pay taxes on the amount you convert, so timing — and planning well in advance of your RMD age — is important. Minimizing your income sources in the year you plan to do the conversion can help keep your tax liability as low as possible.
Many retirees find the "sweet spot" for completing a conversion is after they've stopped working but before they begin receiving Social Security benefits or pension payments.
Your adviser can help you determine if and when a Roth conversion makes sense for your needs.
Don't put off RMD planning
If you expect to withdraw the IRS's required amount — or more — each year to cover your living expenses in retirement, RMDs may not be a concern for you. But if RMDs will impact your income, tax and estate planning, you may want to seek guidance.
The rules are complex, and making a mistake can be expensive.
The IRS website offers basic information regarding the overall RMD regulations. But if you want more specific advice and ongoing support, consider talking to a financial adviser ASAP.
Kim Franke-Folstad contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
Related Content
- How to Calculate RMDs (Required Minimum Distributions) for IRAs
- New RMD Rules: Starting Age, Penalties, Roth 401(k)s, and More
- You're Stuck Taking RMDs: Now What?
- Inherited an IRA? Key Distribution Rules to Know
- 8 Factors to Consider When Considering a Roth Conversion
