Required minimum distributions are no joke. Here's how they might affect your taxes.
The beauty of retirement plans such as 401(k)s and IRAs is the ability to make tax-free contributions to your account and let that money grow tax-deferred until the time comes to withdraw it. But the money in your 401(k) or IRA can't just sit there indefinitely. In fact, once you turn 70 1/2, you'll need to start thinking about required minimum distributions, or RMDs. Your RMD is the mandatory minimum withdrawal you'll need to take from your retirement account, the exact amount of which is calculated based on your age and account balance. There are strict rules regarding RMDs, so you'll need to pay attention to them to avoid major penalties.
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Drawbacks of required minimum distributions
Many seniors who have retirement savings need to access that cash before age 70 1/2 to cover their living expenses. But if you're still working, or have another income source outside of your retirement account, you may not need to touch that money so soon.
The downside of RMDs is that once you reach 70 1/2, you have no choice but to start taking withdrawals. But since those withdrawals are treated as ordinary income, they automatically increase your tax burden. This can be especially problematic if you're still working at age 70 1/2 and earning a fairly high salary, because unless you have a large number of deductions, your RMD could easily bump you into an even higher tax bracket.
Calculating your RMD can be somewhat tricky, but it's important to get that number right. If you fail to take your withdrawal in full, you'll be assessed a 50% tax penalty on whatever amount you were supposed to take out but didn't. So if your RMD for a given year is $6,000 and you only withdraw $3,000, you'll lose $1,500 of that remaining $3,000 automatically. Ouch.
Keep in mind that your initial RMD must be taken by April 1 of the year following the calendar year in which you turn 70 1/2. So if you turn 70 in January 2017, you'll need to take your RMD by April 1, 2018.
Another problem with RMDs is that they limit your assets' ability to grow. When you put money in a retirement account, the goal is to keep it invested so it continues to increase over time. Now once you've reached the age where RMDs come into play, you shouldn't have your savings invested too aggressively, because if you end up needing your money at a time when the market is down, you could lose out. But even once you shift into more conservative investments, you should still, ideally, be generating some sort of return on whatever money you're not using. But the more money you're forced to withdraw, the less you'll have available to grow into an even larger sum.
Avoiding required minimum distributions
RMDs can be a significant burden if you don't actually need the money. Thankfully, there are a few things you can do to avoid them. First, if you open a Roth IRA or 401(k) instead of the traditional version of each account, you'll avoid RMDs entirely. Roth accounts are funded with after-tax dollars, so there's no upfront benefit for contributing. However, when the time comes to withdraw money in retirement, those distributions are tax-free. Because Roth accounts don't impose RMDs, you can let your money sit and grow indefinitely.
You can also avoid 401(k)-related RMDs if you're still working at age 70 1/2 and don't own 5% or more of the company you work for. One you leave your job, those RMDs will kick in, but you can hold off on taking them until you're no longer employed by your company. That said, working into your 70s will only help you get out of RMDs from your 401(k); if you have an IRA, you'll need to take those RMDs regardless of your employment status.
Finally, just because you don't start out with a Roth account doesn't mean you can't end up with one. If you convert your traditional account to a Roth, you'll benefit from tax-free retirement income and the welcome absence of RMDs.
Because required minimum distributions can impact your taxes, taking steps to avoid them can help you save money at a time when you need it the most. Even if you can't avoid RMDs, you should still familiarize yourself with the rules surrounding them so you're not caught off-guard down the line.
FAQs
Key Points
How much would RMD be on $500,000? ›
Here are a couple of examples for someone with an IRA worth $500,000 on Dec. 31, 2023. If he or she is beginning to take RMDs in 2024, at age 73, the RMD would be $18,867.92 ($500,000 / 26.5). Or if this person has already turned 74 in 2024, the distribution amount would be $19,607.84 ($500,000 / 25.5).
How do you avoid taxes on required minimum distributions? ›
4 Strategies for Avoiding Taxes on Your RMDs
- Avoid Taxes on RMDs by Working Longer. One of the simplest ways to defer RMDs and the taxes on those withdrawals is to continue working. ...
- Donating to Charity. ...
- Minimize RMD Taxes With a Roth Conversion. ...
- Consider an Annuity.
As with annual distributions, there is no best way to handle this money. Some retirees prefer taking a lump sum distribution each year. Others prefer a series of smaller monthly withdrawals. It's all up to you.
What is the RMD 10 year rule? ›
The proposed RMD regulations clarify that designated beneficiaries of account owners that die on or after the RBD must take life expectancy payments for the first nine years, and a total distribution by December 31 of the year containing the 10th anniversary of the account owner's death.
What is the 4% rule for RMD? ›
The 4% rule limits annual withdrawals from your retirement accounts to 4% of the total balance in your first year of retirement. That means if you retire with $1 million saved, you'd take out $40,000. According to the rule, this amount is safe enough that you won't risk running out of money during a 30-year retirement.
What is the RMD on $100000? ›
Let's say you have a combined $100,000 in your tax-deferred retirement accounts: $100,000 divided by 24.7 is $4,049 — which is the amount you must withdraw. If you are in the 25 percent combined state and local tax bracket, you'll owe $1,012 in taxes on your RMD.
Do RMDs affect Social Security? ›
RMDs generally increase an account owner's taxable income. Certain Social Security and Medicare calculations can be impacted. For example, a portion of Social Security benefits can be taxed for those whose RMDs push them above certain income thresholds.
Why are RMDs bad? ›
Required minimum distributions can have a significant impact on your retirement income. If you miss withdrawal deadlines or withdraw the wrong amount, it may trigger costly consequences, including a tax penalty of 50% on your RMD and bumping you into a higher tax bracket for the year.
What is the one word secret to lower the tax hit on your IRA RMDs? ›
The one-word secret? Charity. By using a qualified charitable distribution, or QCD.
#1: RMD Calculation Rules and Errors
The number 1 error that we see is RMD calculation rules and errors. So, using the wrong balance, the wrong life expectancy, and/or the wrong age can be disastrous. Use the December 31st balance of the year before the distribution year.
What is the disadvantage of RMD? ›
Drawbacks of required minimum distributions
The downside of RMDs is that once you reach 70 1/2, you have no choice but to start taking withdrawals. But since those withdrawals are treated as ordinary income, they automatically increase your tax burden.
What is the best time of year to take RMD? ›
If you need or want more income sooner rather than later: Taking only the RMD and doing so at the end of the year is usually the most tax-efficient choice.
Should I have taxes withheld from my RMD? ›
Tip: Many people choose to have taxes withheld from their RMDs, as it is counted as ordinary income. If you choose not to do this, make sure you set aside money to pay the taxes. And be careful—sometimes underwithholding can result in a tax penalty.
Can I reinvest my RMD into a Roth IRA? ›
While you can reinvest these withdrawals in taxable accounts, the IRS restricts how you can fund tax-advantaged accounts like a Roth IRA. Among those restrictions: you can only make IRA contributions with earned income. As a result, you can't use RMDs to directly fund a Roth IRA.
At what age is IRA withdrawal tax-free? ›
If you're at least age 59½ and your Roth IRA has been open for at least five years, you can withdraw money tax- and penalty-free. See Roth IRA withdrawal rules.
What is the RMD on $750000? ›
To find your RMD, divide $750,000 by 26.5 to get $28,302. That's the amount you must withdraw by April 1, 2025, to avoid IRS penalties. All subsequent RMDs must be taken out by December 31 of each year.
How do I calculate my RMD amount? ›
Generally, a RMD is calculated for each account by dividing the prior December 31 balance of that IRA or retirement plan account by a life expectancy factor that the IRS publishes in Tables in Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs).
What is the RMD on 1 million? ›
If your IRA balance at year-end is $1 million and you're 73 years old, your life expectancy factor is 26.5 according to the IRS. Divide your balance by 26.5 ($1,000,000/26.5), and that equals $37,735.85, which is your RMD amount.
What is the RMD on 250000? ›
Or, the federal government provides an RMD calculator to help estimate your annual required minimum distribution. According to the calculator, a taxpayer aged 75 with a balance of $250,000 in their traditional IRA would be required to withdraw roughly $10,200 from their account in 2023.
