Required Minimum Distributions (RMDs) have been a part of the financial news cycle for the last year, with the SECURE Act raising the starting age to 72 and the CARES Act suspending them for 2020. These changes signify the vital role RMDs play in your financial plan.
RMDs impact your retirement income plan, projected annual tax bill, and retirement lifestyle, making it necessary to build a plan that works for you. To do that, you’ll need to understand what they are, how they work, and the many ways they influence your journey.
What is an RMD?
The IRS mandates annual required minimum withdrawals from qualifying accounts. RMDs are associated with accounts that have previously seen tax deductions, like traditional IRAs and 401(k)s.
Your RMDs are taxed as ordinary income, just like a salary, which makes sense because the government wants to collect taxes on money that has been growing tax-free for decades.
An RMD is any amount you must withdraw from a retirement account within a calendar year. Your annual RMD will shift depending on your age, life expectancy, and account balance.
When do RMDs Start?
The SECURE Act instituted important RMD changes. Anyone who turned 70 ½ in 2020 or beyond could delay taking RMDs until April 1 in the year after they turn 72. Those who reached 70 ½ in 2019 or earlier must abide by the old rules. Extending RMDs to 72 gives retirees more time to contribute to their accounts and let their investments compound.
After your first RMD, others in following years must be taken by December 31, meaning you could have to take two separate distributions in the first year to comply with the rules and avoid a penalty. Let’s look at an example.
Ann’s 72nd birthday is in October of 2021. Technically, she doesn’t need to take her RMD until April 1, 2022. Should she decide to wait, however, she would also need to take another RMD by December 31, 2022, to account for both the current (2022) and previous (2021) years.
Since RMDs are taxed as ordinary income, a double distribution can negatively impact your tax situation, whether inadvertently bumping you into a higher tax bracket or simply increasing your annual taxable income. A bump in your tax circumstances doesn’t just impact your taxable income, it also affects the taxable portion of your Social Security benefits, your Medicare premiums, and more.
Most people benefit from taking their first RMD in the year they turn 72, instead of waiting until the next April. Everyone’s financial situation is different, so be sure to work with your tax professional and financial advisor to make a plan that suits your needs.
Is There a Penalty if You Don’t Take Your RMD?
Unfortunately, there is a hefty penalty for not following the IRS rules. There are two ways you can trigger this penalty:
- Forgetting to take your RMD altogether.
- Withdrawing too little from qualifying accounts.
If you find yourself in this situation, the IRS will issue a 50% penalty on the money that was supposed to have been withdrawn. This makes taking RMDs a critical component of your annual financial housekeeping schedule.
How to Calculate Your RMD
RMDs change each year and are dependent on two factors, your age and account balance. Calculating your RMD for the year is simple–just follow these three steps.
- Obtain your account balance from December 31 of the year prior.
- Find your age on the IRS Uniform Lifetime Table.
- Divide those two numbers to get your result.
Let’s bring back Ann to demonstrate how this process works. Remember, Ann turns 72 in October 2021 and is preparing for her first RMD from her Traditional IRA. If she wants to take it by December 2021, she would need to get the account balance as of December 31, 2020, which was $200,000, and divide that by her IRS life expectancy factor which is 25.6. That would make Ann’s first RMD from her traditional IRA $7,812.
Ann would need to repeat this same process for each account that needs an RMD. It’s also important to note that any additional distributions won’t count toward next year’s RMD. So if Ann decided to withdraw $10,000 as opposed to the $7,812, the remaining $2,188 can’t be applied to next year’s RMD. Each RMD is independent year after year.
Which Accounts Qualify?
Several tax-advantaged accounts are subject to RMDs. Nearly every account that allowed tax-deductible contributions will make it on this list. The IRS notes the following accounts have RMDs:
- Traditional IRA
- Rollover IRA
- Inherited IRA
- SEP IRA
- SIMPLE IRA
- SARSEP IRA
- 401(k)
- Roth 401(k)
- 403(b)
- 457(b)
Roth IRAs are the only tax-advantaged retirement accounts not subject to RMDs. Roth IRAs are special because they are funded with after-tax (non-deductible) dollars, gains grow tax-free, and all qualified distributions remain tax-free. Since taxes were paid on contributions, they don’t have to be paid on distributions, provided the account owner follows the rules.
The only time that you would need to take RMDs on a Roth IRA is if you inherit it. The rules for inherited IRAs are different, so be sure to work with your financial advisor to build a plan that’s best for you.
RMDs are calculated per account, so if you have multiple accounts that mandate RMDs, you’ll need to calculate those separately. Meaning, if Ann has a traditional IRA and a 401(k), she would need to calculate the RMD for both accounts each year.
RMDs and Inherited IRAs
RMDs and Inherited IRAs have a complex relationship. The rules you have to follow depend on the type of account you inherit (traditional or Roth) and your relationship with the grantor (spouse, non-spouse, trusts).
Let’s start with a Roth. If you inherit a Roth IRA and transfer it to an Inherited Roth IRA, you need to take RMDs. As long as the assets have been in the account for at least 5 years, your RMDs aren’t taxed as federal income. (You might incur state taxes depending on inheritance/estate tax laws.)
Should you inherit a traditional IRA, your RMDs will be counted as ordinary income. The SECURE Act brought about an unpopular provision regarding inherited IRAs and RMDs. A non-spouse beneficiary must withdraw all the funds from the inherited account within 10 years. Before this rule, beneficiaries could “stretch” RMDs over their lifetime. Eliminating the stretch rule means that beneficiaries may experience severe tax consequences for large inherited accounts.
Spousal beneficiaries have the most flexibility as they can roll the assets into their own IRA, establish an inherited IRA, or convert the account to a Roth IRA. Each of these options creates different RMD and tax treatments. Make a plan with your professional team (financial advisor, tax professional, and estate planning attorney) to best accommodate your needs.
How RMDs Impact Taxes
As mentioned above, RMDs count toward your annual taxable income. Many retirees worry about their RMDs bumping them into a higher tax bracket (known as “bracket creep”), which also impacts the taxable portion of Social Security benefits, the cost of Medicare premiums, net investment income tax, and more.
Any vehicle that adds to your income in retirement needs to be accounted for to manage your tax and Medicare exposure. The way you approach taxes in retirement changes. You need to be even more mindful of the many income channels you have to organize your income in a tax-efficient way.
Bringing tax-efficiency to your RMDs isn’t easy, but there is one strategy that can help if you don’t need the RMD for living expenses: qualified charitable distributions (QCDs) from your IRA to one or more charities you wish to support. IRA distributions using QCDs do not count as taxable income, so they help prevent bracket creep. They can also satisfy your RMD, up to $100,000. QCDs must be distributed directly from your IRA to a charity. If donors want to make QCDs to several different charities, they should request a checkbook for their IRA account. Donating through this vehicle can save you on taxes while also maximizing your charitable efforts. Contact your advisor to learn more about QCDs and if they are right for you.
The Bottom Line
RMDs influence much of your retirement plan, from your income and taxes to your estate plan and charitable contributions, making it critical to create a unique plan that suits your needs. It’s vital to create your retirement plan around what matters most, and our advisors at Abacus want to help you expand your possibilities and open up new opportunities for your finances. This year might mark your first RMD or you just may want to see if there is a better way to use your RMDs. Either way, we encourage you to reach out to us today.
