Spelling Out the RMD: Understanding Required Minimum Distributions

Are you about to celebrate your 70 1/2 birthday? Do you have any tax-deferred retirement accounts, such as a traditional IRA, 401(k), 403(b), profit-sharing, SEP IRA, SIMPLE IRA, or other defined-contribution plan?

If so, you’re about to get familiar with three letters: RMD. What is RMD, you ask? It’s short for required minimum distribution—an amount the government requires you to take from your tax-deferred accounts each year. (The exception is a Roth IRA—more on that in a bit.) More importantly, as you take each distribution, you’re essentially declaring it as income, which means it’s time to pay taxes on it.

Here are a few things to consider as you plan for those required minimum distributions.

Give Me an R

It’s required. According to RMD rules, failure to take one can be costly, as the IRS will assess a penalty in the amount of 50% of the difference between your RMD and what you actually withdrew from your tax-deferred accounts. For example, if you have an IRA with a required minimum distribution for the current year of $12,000 and you only took, say $5,000, you'd be assessed a penalty of half the $7,000 difference, or $3,500. Yowza!

After decades of diligent saving, all while allowing your nest egg to grow with no taxes assessed along the way, it’d be a shame to take such a massive hit. So it’s important to pay attention to the RMD rules.

Give Me an M

It’s a minimum amount. Why does the IRS care if you take a minimum amount each year? In a word: taxes. Tax-deferral can be a generous incentive, one that was put in place to encourage people to save for retirement. Once you reach retirement age, it’s mission accomplished, which means, as far as the IRS is concerned, it’s time to pay taxes on at least a minimum amount each year. 

When you turn 59 1/2, you can begin taking distributions and paying taxes on them, but doing so isn’t mandatory until age 70 1/2. If you continue working, or if you simply have no need for the money, there’s probably no reason to start taking distributions early. In fact, when you’re working, you might still be contributing to a plan. Once you turn 70 1/2, though, you can defer no longer.

One side note: If you’ve made nondeductible contributions to an IRA over the years, those might not be taxable, but they’ll still be figured into the RMD calculation (more on nondeductible contributions below).

Give Me a D

It’s a distribution, and here’s what you need to know.

RMDs will vary from person to person and account to account and are based on two factors:

• The fair market value of your account on December 31 of the previous year.
• What the IRS calls your “distribution period," quoted in years, which is essentially a life expectancy based on your age, your spouse’s age (if applicable), and how you may have structured certain beneficiary arrangements.

To figure the RMD amount for any applicable retirement account, you divide the account balance by the distribution period, as shown in one of three tables provided by the IRS (worksheets and tables are available on the IRS website). Most likely, though, you won’t be required to do the math; typically the custodian of each of your eligible accounts—a broker, bank, or plan sponsor, for example—will calculate the RMD for you each year.

What’s That Spell? RMD!

According to RMD rules, the first one is due the year you turn 70 1/2, but you can postpone it until April 1 of the following year. After that first year, the annual deadline is December 31. Although you can delay that first RMD into the next calendar year, that means you’ll be taking two in that second year: one by April 1, the other by the end of the year.

But here’s an R you can ignore (somewhat) when considering RMDs: Roth. If you have a Roth IRA, no RMD is required. Unlike a traditional IRA, where funds are tax-deferred until withdrawn, a Roth IRA is taxed up front and is tax-free when you take it as a distribution. However, this is only true during the owner's lifetime. Afterward, a Roth IRA is subject to RMDs, and the same 50% penalty will apply, unless a surviving spouse is the sole beneficiary. A surviving spouse who inherits a Roth IRA can become the new account owner (by rollover) and wouldn't be subject to RMDs during his or her lifetime.

Also, though Roth IRAs don't require minimum distributions, Roth 401(k) plans do, so you can't ignore Roth 401(k) accounts. If you have money in a Roth 401(k), and you wish to sidestep the RMD, you might consider rolling the 401(k) into a Roth IRA. 

Here are a few more facts and considerations about RMDs:

• Consider those taxes. An RMD counts as ordinary income in the year taken. It will be added to all your other sources of income, including Social Security, so it can affect not only your tax bracket but also your Social Security taxation. Remember: If your household income is above a certain threshold, some of your Social Security benefits may become fair game for inclusion as taxable income.
• Remember nondeductible contributions. If you made nondeductible IRA contributions or Roth or after-tax contributions to your 401(k), then part of your RMD may not be taxable at all. For a traditional IRA with nondeductible contributions, you calculate the taxable portion of your RMD using IRS Form 8606 that you've used to track your nondeductible contributions. For your 401(k) RMDs, your plan administrator can assist you in determining the taxable amount of your distribution.
• Multiple accounts mean multiple RMD calculations. If you have more than one IRA account, your RMD will be based on the combined assets. However, you may allocate your IRA RMDs as you choose. For example, if you have two IRAs, each with a $1,000 RMD, you could opt to take all $2,000 from one account if you wish. And if you also have a defined-benefit plan such as a 401(k) or 403(b), you’ll have a separate RMD calculation for that one. But, unlike IRAs, if you have multiple 401(k)s, you’ll need to take the defined RMD amount from each one. 
• Still working after age 70 1/2? There’s an RMD exception. If you work past age 70 1/2, you can postpone the RMD on your current company's qualified retirement plan—401(k), profit sharing, or money purchase pension plan, for example. You'll need to begin taking RMDs from the plan by April 1 of the year following your retirement. But again, this is only for your current company. Any retirement plans from previous jobs will require RMDs once you turn 70 1/2. 
• Business owners: Pay attention. If you're a business owner (or the spouse of an owner and you're in the plan), you must take RMDs as of age 70 1/2 regardless of whether you're still working. That's true for anyone who owns more than 5% of the company. 
• Inherited IRAs. When an IRA is passed down due to the death of the original account owner, the person inheriting it will be required to take an annual distribution. How much of one depends on several factors, including whether it was from a spouse or not, the type of account, the amount of assets in the account, and the age of the beneficiary.

These rules can get tricky, so if you’re at all in doubt, consult a tax professional for more information.

Bottom Line on RMDs

Required minimum distributions shouldn’t be considered a government tax grab but rather a fact of retirement investing. If you’ve saved and invested diligently over the years, you’ve likely gotten the better end of the deal tax-wise, as investments hopefully grew without taxes being assessed along the way.

You don’t have to liquidate holdings to take the RMDs, but rather, you can transfer securities into a taxable account if you wish (see sidebar). Just know that you’ll need to pay taxes on the value of such securities at the time of transfer. Plus, you might be required to pay transfer fees. Some investors choose to liquidate enough securities to cover the tax bill, then transfer an amount equivalent to the RMD into a taxable account.

And remember, if your budget allows it, you could use the RMD as additional “fun money.” After all, isn’t that what retirement is all about?