When you contribute money to a 401k or a traditional IRA, you receive a tax deduction. Your money grows tax-deferred until you withdraw it from your account. However, if you don’t withdraw it from your account, the government doesn’t get its revenue.
As a result, at some point, the government requires you to withdraw money from your retirement accounts so that you can pay taxes. This is known as a required minimum distribution (RMD), and you need to be prepared to take it each year after you reach a certain age. It’s important that you plan for RMDs, since if you don’t take the require distribution, the penalty is 50% of what you should have taken — on top of being required to take the distribution and pay taxes.
Those who are 70 1/2, and no longer working, are required to take RMDs from their retirement accounts. It’s actually possible to delay your first distribution, though, until the April following the point where you turned 70 1/2. So, if you turned 70 in December 2012, you weren’t 70 1/2 until June 2013. This means that you don’t actually take your RMD until the beginning of April 2014.
However, if you delay, you still have to take your regular RMD for the year. So, if you delay your first required distribution, you’ll have to take your “regular” 2014 distribution by December 31 of that year. Essentially, by delaying, you end up being required to take two years’ worth of RMDs in one year.
If you have a Roth IRA, you don’t have to RMDs from that account. But you do need to take RMDs from your Roth 401(k), as well as a 403(b) and 457 accounts in addition to the traditional IRA and regular 401(k).
Your required distribution is figured out at the beginning of each year. It should be determined on each of your accounts individually. If you are still working, and you have a retirement account with your employer, you don’t have to take an RMD from that account; all your other accounts are still subject to the RMD and should be figured accordingly.
The amount you have to take is determined by a formula that includes your life expectancy, as well as the account balances of your retirement accounts on December 31. Your RMDs will vary each year, according to your situation. There are worksheets you can use to figure your RMD, and your account custodian(s) might figure it for you as well.
Visit IRS.gov to see the Required Minimum Distribution Worksheets.
Once you determine your RMD for each account individually, you can work out a plan to take the money. With IRA accounts, it’s possible for you to take the RMDs for all of your traditional IRAs from a single account. This is also possible for those with multiple 403(b) accounts. (But you should still figure the RMDs for each account separately.) RMDs from 401(k) accounts and 457 accounts cannot be combined.
You can decide to take your RMDs throughout the year, or you can take them all at once, at any point during the year.
Of course, the point of RMDs is that you pay taxes on your money — and on your capital gains. So you will be taxed on the money you are required to withdraw from your account. Since the IRS prefers that you pay regularly, most retirees pay quarterly taxes. Since you know your RMDs for the year, and since you probably have a rough idea of the income you will have from other sources throughout the year, it’s possible to smooth out the process and just divide your tax bill by four and then pay the each quarter.
It’s also possible to use your RMD as your tax payment, and avoid paying quarterly estimated taxes. You would need to direct your custodian to withhold the amount of your tax as your RMD. So, if you owe $8,000 in taxes for this year, instead of paying in four installments of $2,000, you have the $8,000 witheld as tax from your RMD in December. You get to keep your money longer, your taxes are covered, and your RMD is met.
Realize that your RMDs are added to your other income and you are taxed at your marginal rate. Your RMDs can bump you up a tax bracket as well. Also, because of the way RMDs work, you will end up paying your marginal rate on capital gains. Some retirees decide to have their RMD taken in security form. The taxes still have to be paid, but future gains, as long as the security is considered a long-term asset, are at a lower rate. This works well if you think that your assets will appreciate.
RMDs are a reality for many retirees, and you need to be prepared. Consult a retirement or tax specialist to help you figure out the best approach.
Photo credit: Rob and Stephanie Levy.