Nobody said the US tax code was simple. In this installment of Back to the Basics, we’ll tackle a small part of the tax code that can have big consequences for retirees if not handled correctly: the RMD.
A required minimum distribution is the amount the federal government requires you to withdraw each year – usually after you reach age 70-1/2 – from retirement accounts, including traditional IRAs, simplified employee pension (SEP) IRAs, SIMPLE IRAs, and employer sponsored plans such as 401(k) and 403(b) accounts. Because these accounts allowed you to deposit money before being taxed on the contribution, the RMD forces you to pay taxes on that money, by requiring you to withdraw it and add that amount to your other income sources.
For some retirees, the RMD amounts are being met simply because withdrawals from retirement accounts are needed to create the necessary income to pay for lifestyle expenses. For others, the RMD represents a nuisance, something to be loathed, because it results in taxes being paid on withdrawals not needed to pay for retirement expenses. For these retirees, there are strategies available to minimize the taxes due, or to create a silver lining through planning that would otherwise not have been as apparent.
Before we discuss strategies, it’s critically important to mention the consequence for not withdrawing the necessary amount of RMD each year. For RMDs that did not occur or were not adequate, the penalty is 50% of the amount that was required to be withdrawn. That’s right, if you needed to take $20,000 out of your various tax qualified accounts, but you forgot, you would owe a $10,000 penalty. Because of this steep penalty, it truly pays to understand the RMD and how to calculate it.
In order to determine your RMD, the chart lays out the factors for people at various ages.
For a person who is 71, for example, they would total their qualified accounts (traditional IRA, 401(k), etc.) and divide that number by 26.5. Or, $500,000 divided by 26.5 = $18,867. That’s roughly 3.8%. That’s the amount that needs to be withdrawn in that year for a person who is 71, who has $500,000 in qualified accounts. If you calculate the amount correctly, you can generally withdraw the money from just one account to meet the RMD for all accounts, in aggregate. Each year thereafter, the same process is used, but using a different Distribution Period.
As you can imagine, there are a host of options for how to handle the money that is withdrawn: it can be spent, reinvested, or given away. The spending is easy, it’s the reinvesting and/or giving away that warrant some planning. Some retirees will use a portion of the withdrawal to fund long term care protection. Some will simply reinvest in a similar investment portfolio but outside an IRA, while others will fund life insurance to leave a larger tax-advantaged legacy for a future generation. The options are many, they just take some thought in order to align your planning with your intentions.
The biggest warning is this: be VERY clear about who is to calculate your RMD: is it you or is it an advisor? This time, each year we work with our over age 70 clients to ensure calculations are being done. If you’re not sure what to do or how to do it, reach out to us and we’ll be happy to help.
The tax deferral you received over all of those years played a big part in your ability to accumulate wealth. Now that it’s time to withdraw the money, it’s prudent to ensure it’s being done correctly and in alignment with your overall goals.