This article is about the basics, the ins and outs of Required Minimum Distributions (RMDs) from tax-deferred retirement accounts. Even if you are nowhere near retirement, you might still find this information helpful for the future, especially if you are the beneficiary of someone else’s retirement account. If you read the financial news online, in magazines or newspapers you have undoubtedly seen articles about RMDs. You also have probably seen articles discussing retirement planning and suggesting how much you should take out of retirement accounts in order to ensure the money in those accounts will last long enough to support you through 25 or 30 years of retirement. Few of the articles integrate these two topics. We’ll explain why that’s important and provide links to the pertinent IRS pages that explain RMDs.
What are RMDs?
They’re amounts that must be withdrawn from retirement accounts each year if the account or plan was funded by untaxed (before tax) income. The RMD is a minimum; you can take out more but not less. We will discuss why that might be appropriate later in the article. For more details on all of this, begin with this page on the IRS.gov site.
Who does it apply to?
Anyone who contributed to a retirement plan or account with tax deferred (before tax) income. Congress established a long list of retirement options, some of which go by a descriptive name and others that are named for their respective section of the Internal Revenue Code. For example, there are defined contribution plans such as 401(k), 403(b) or 457(b) or profit-sharing plans. Then there are traditional IRAs and IRA-based plans. The RMD rule does not apply to Roth IRAs but does apply to Roth 401(k) plans [however, no tax will be due on the Roth 401(k) in most cases].
When must you start taking RMDs?
It depends on whether you are in a defined contribution plan or an IRA, but for most purposes the result will be the same. The first RMD must be taken by April 1 of the year after you reach age 70 ½. [If you are in a defined contribution plan and don’t retire until after that age–then it’s April 1 of the year following retirement. See the IRS chart for more exceptions.] So if your birthday is before July 1, you will be 70 ½ that same year and your first RMD will be the following year. If your birthday is on July 1 or after, your first RMD will fall on the year after that. For example, if Bob turns 70 on May 2017, his first RMD will be April of 2018. If Mary turns 70 in August of 2017, her first RMD will be in 2019. Note: the second RMD and all that follow must be taken by December 31 of the year following the year you reach 70 ½. So that means if Bob takes that first RMD April of 2018, he will have to take the second one that same year, by December 31. Depending on your tax situation and income needs, that may not be your best option. You don’t have to wait until April of the next year; you can take the RMD the same year you turn 70 ½ to avoid two taxable events in the same year. Note: You don’t have to wait until the last minute either; you can take a distribution any time during the year or in multiple instalments, provided your plan permits that.
How do you calculate your RMD?
It’s calculated by dividing the balance in the retirement account on December 31 of the prior year by a distribution period. For example, if your RMD is due in 2017, the calculation will be based on the balance as of December 31, 2016. So what’s the distribution period? It’s based on your life expectancy, which changes each year. For example, when you are 70, the Uniform Lifetime Table assumes you will be receiving an RMD for 27.4 years and divides the account balance by that number to calculate your RMD. When you’re 85, it assumes you have 14.8 more years of distributions. Obviously, that means the longer you live, the bigger the RMD you must take each succeeding year (assuming the account balance doesn’t decline). [Which is why you need to make sure that you are still are earning enough of a return on the money in your account to continue getting the distribution and that it meets any needs you may have for income.]
If you have a spouse that’s more than ten years younger than you are and is the sole beneficiary of your account then the Joint Life and Last Survivor Expectancy Table establishes the divisor to calculate the RMD. It gets a little more complicated for how to deal with inherited retirement plans or accounts and RMDs. See the IRS explanation “Required minimum distributions after the account owner dies” 2/3 of the way down on the IRS explanation page, and consider this article from Kiplinger.
Your IRA custodian or plan administrator may do the calculation for you. At the least, they will probably send you forms to fill out online or by mail to schedule your RMD before it’s due. But take note that the IRS holds you responsible for the correct distribution, not them. If you don’t take a distribution by the time it’s due or don’t out enough, the IRS may penalize you 50% of the amount you should have taken out.
What if you have more than one retirement plan or account?
It gets a little more complicated. On their FAQ page the IRS answers this question,
Can an account owner just take a RMD from one account instead of separately from each account?
An IRA owner must calculate the RMD separately for each IRA that he or she owns, but can withdraw the total amount from one or more of the IRAs. Similarly, a 403(b) contract owner must calculate the RMD separately for each 403(b) contract that he or she owns, but can take the total amount from one or more of the 403(b) contracts.
However, RMDs required from other types of retirement plans, such as 401(k) and 457(b) plans have to be taken separately from each of those plan accounts.
Planning your RMD in conjunction with other income
There are many ways people fund their retirement—pension plans, social security, ordinary savings and Roth IRAs. This article is not about them—but we do want to include coordinating income from them along with the RMD’s you will get from your tax-deferred funds. You have probably seen many articles warning you about making sure your retirement income will last for a longer than expected retirement. Some articles suggest percentage amounts, often 4% to start, that you should withdraw from retirement accounts. When they do that, they seldom mention RMDs—they’re usually talking about taxable investments. It also assumes a reasonable rate of return on the funds in those accounts. So what should you do?
If you have other savings or taxable investments, you may want to consider the RMD first in finding the means to make up any shortfall between income and expenses in your annual budget. But if those investments are in stocks or mutual funds that offer a tax savings because of capital gains you may want to take some of them first. If you don’t understand how to evaluate that, then it’s time to consult a financial advisor or tax professional. Generally, taking nontaxable investments, like Roth IRAs and tax-exempt investments comes last—giving them more time to grow.
So, back to the RMD. If your calculation is based on, for example, the Uniform Life Table, the percentage of your retirement account balance when you are 70 will be 3.6% (based on the 27.4 distribution factor)—close to the 4% you often see recommended to start with. You can take more, but you can’t take less; that’s the required amount. By the time you reach 80, the percentage the RMD takes is 5.3%. It keeps going up the older you get. So what you need to do to coordinate what the RMD will yield and then figure out how much more you need from the other retirement funds. That may result in more or less than the 4% estimate. If your tax-deferred account subject to the RMD is your only source, then you will need to take more than the RMD or reduce expenses. If you do have other sources, then you can take whatever you need and maximize the earnings of the account(s) subject to the RMD. Just make sensible choices, based on your risk/reward tolerance. The riskier your investments, the more potential there is for greater rewards—or losses. If you will depend on these tax-deferred accounts and taxable investments for support, then you can’t afford to be too risky. If not, then you can be a little more aggressive, if you like, in growing them for luxury items, gifts and an inheritance for any beneficiaries.
For more information on the IRS rules, consult these publications:
- Publication 590-B, Distribution from Individual Retirement Arrangements (IRAs) (includes life expectancy tables)
- Publication 560, Retirement Plans for Small Business (SEP, SIMPLE and Qualified Plans)
For more information on rules applicable to IRAs (Individual Retirement Arrangements; not Individual Retirement Accounts as some people think) check this IRS page.
Disclaimer: This article is for general information on the subject. Nothing herein should be taken as legal advice or specifically applicable to your situation.
Coming in our next financial piece, we’ll cover Roth IRAs versus tax-deferred accounts. It’s an important planning task for those starting out in the workplace or for those with time to adjust before retirement.