A Guide to Required Minimum Distributions (RMDs)

Individual retirement accounts (IRAs) were first created by Congress in 1974 to help workers take more control over their retirement savings. In 1978 the 401(k) was created, and the Roth IRA came into existence in 1997.

With the decline in traditional pensions these individual retirement accounts have become a critical source of retirement income for most Americans.

However, while there are several major benefits to these plans, they also have an important stipulation called "required minimum distributions" (RMDs).

Let's take a look at what investors need to know about RMDs, and how they will affect your taxes in retirement.

What are Required Minimum Distributions?

Retirement accounts are designed to incentivize retirement savings by offering significant tax benefits. For example, traditional IRA contributions are tax deductible for both Federal and state income taxes.

This means that your adjusted gross income (total gross income minus specific deductions) is reduced by how much you contribute each year, up to the maximum allowed level.

Following the 2017 Tax Cuts and Jobs Act (tax reform) the current annual contribution limitations for 2020 are:

  • Traditional IRA: $6,000
  • Traditional IRA (those over 50): $7,000
  • Roth IRA: $6,000
  • Roth IRA (over 50): $7,000
  • 401(k): $19,500
  • 401(k) (over 50): $26,000

Individual 401(k) contributions reduce your taxable income as well, and unlike traditional IRAs and Roth IRAs, often an employer will match part of your 401(k) contribution, effectively giving you free (tax-deferred) money with which to invest. 

Roth IRA contributions are not tax deductible; however, Roth accounts have their own major advantage in that you never have to pay taxes on withdrawn funds as long as you avoid pulling money out before the age of 59½.

For traditional IRAs and 401(k)s, you will eventually have to pay taxes on all proceeds (except any non-deductible contributions that were made so you avoid double taxation), including capital gains and dividends. 

The tax rate that is applied is the same rate that you would pay if you were receiving a regular paycheck from a job. Following tax reform, here's a look at the current marginal tax bracket for 2020:
Source: MarketWatch
Besides a few limited exceptions, you can't withdraw money from an IRA or 401(k) before the age of 59½ (same with Roth IRA) without paying a 10% penalty on the proceeds.

To prevent individuals from permanently deferring taxes in these accounts by never withdrawing if they don't need the money, Congress put in place a mechanism to ensure that the IRS would eventually be able to collect taxes on these accounts – required minimum distributions.

RMDs are the minimum amount of tax-deferred savings an individual must withdraw each year and pay income taxes on based on their highest marginal tax bracket.

The Basics of RMDs

RMD requirements apply to nearly all retirement accounts including:

  • Traditional IRAs
  • SEP IRAs (IRAs for self employed and small business owners)
  • SIMPLE IRAs (IRAs for small business owners that provide a match for employee contributions)
  • 401(k)s (assuming the account owner is no longer working)
  • 403(b)s (tax sheltered annuity plan for teachers, employees of tax-exempt charities and ministers)
  • 457s (mostly for government workers)
  • Thrift savings plan (TSP)

In late 2019, Congress passed changes to retirement savings law, including bumping up the age at which RMDs kick in from 70½ to 72. (However, note that this change only applies to investors who turn 70½ after December 31, 2019.)

For traditional IRAs, RMDs kick in the following year after April 1 of the year you turn 72. For example, if you turn 72 in 2023, then you don't have to withdraw your first RMD until April 1, 2024. In each subsequent year you have until the end of the year to withdraw the RMD for that year.

So if you turn 72 years old in 2023, then you would have to take out (and pay income taxes on) your 2020 RMD amount by April 1, 2024. You would also have to take out your RMD for 2024 by the end of 2024.

If the account owner dies before the age of 72 their beneficiary (who inherits the account) has two options.

The first option the beneficiary has is to distribute the entire account's value within 5 years of the owner's death.

Alternatively, the beneficiary can distribute the account's value over the later of his or her life expectancy starting the year after the account owner's death or the year in which the account owner would have turned 72. 

While Roth IRA owners do not face RMD requirements (the money they originally contributed was already taxed), their beneficiaries who inherit their Roth IRAs do. Upon inheriting a Roth IRA, the beneficiary must calculate his or her RMDs as if the account owner had passed away before the age of 72, even if that was not the case in reality.

It's important to note that RMDs are just the minimum you are legally required to withdraw. You are free to withdraw as much as you want from any retirement account after the age of 59½.

And if you have multiple IRA accounts, you can choose to withdraw your RMD in any manner you wish. That means from just one account, or across several. The income taxes you pay will be the same either way, but you can be a little strategic depending on issues like which account might be holding more cash, or perhaps you have a small account that can be closed to reduce future paperwork hassles. 

Now we know what RMDs are, what accounts RMDs apply to, when we have to start paying them, and what tax rates we'll face. But how much is the minimum distribution you are required to withdraw each year? This is where things can get complicated.

How To Calculate RMDs

Your actual RMDs for any given year are based on one of two tables (and formulas) determined by the IRS. Most people will fall under the Uniform Lifetime Table and be required to initially withdraw about 3.9% of their tax-deferred retirement assets, with that proportion growing over time as they age. 

The only exception is if your beneficiary (usually your spouse) is 10 years or more younger than you. Since they are expected to outlive you if this situation applies, then you need to use the Joint Life and Last Survivor Expectancy Table, which you can find in IRS Publication 590-B.

To calculate your RMDs for any given year you need two things: your total retirement account balances as of December 31 of that year, and the age you reach that year.

Most retirees will use Table III below to determine what's called the "distribution period". This is the IRS's estimate of how long your retirement is likely to last based on the latest actuarial data and your given age. You then divided your total retirement account balance by the distribution period to determine your RMD for that year.

For example, if you have $500,000 in retirement account value and turn 72 in 2023, then your distribution period would be 25.6 for this year your RMD would be $19,531 ($500,000 divided by 25.6).

If you are in the 25% tax bracket (like most retired Americans are per the latest data from U.S. Census Bureau), then you would owe $4,883 in taxes on this amount.
Source: IRS
Note that the distribution period gets progressively shorter over time because the IRS's goal is to recapture as many of the deferred tax benefits as possible that you've accrued over your retirement savings career.

For example, by the age of 100 your RMDs equal 15.9% of your entire remaining retirement account balance, and if you live to 115 they total nearly 50%.

RMDs can be taken monthly, quarterly, or annually. The taxes you owe will remain the same regardless of your withdrawal schedule. 

However, if you can afford to wait, taking a lump sum distribution at the end of the year gives your retirement investments the longest possible amount of time to grow tax-free. 

Importantly, RMDs do not have to be taken in cash. "In kind" withdrawals are permitted, which allows you to potentially transfer your investments to a taxable account rather than selling them (more on that later). 

Finally, it is important to note that if you have a spouse with a separate IRA, you are both required to take RMDs from your own accounts; one spouse cannot take the entire required payout for both. 

Complications With RMDs

There are some important complications that individuals need to be aware of pertaining to RMDs. Specifically that the RMD amount is considered taxable income.

As a result, the tax bracket you fall under, which determines your tax liability for RMDs, can be increased to a higher level by them as well. This is especially important to understand for those making their first RMD.

For example, say that you are turning 72 in 2023, so you don't have to make your first RMD until April 1, 2024. You could technically wait until then to do so, and thus avoid paying any RMD taxes for 2023.

However, remember that you have to take your RMD (and pay taxes on it) by the end of each year. Therefore, anyone pushing off their first RMD until the next year (2024 in our example) would actually have to take two RMDs that year.

This means that, assuming your tax-deferred retirement account balances totaled $500,000 on December 31, 2020, you would actually have 2024 RMDs of $19,531 (2023 RMD) + $19,452 (2024 RMD) which totals $38,983.

This second RMD could potentially push you into a higher tax bracket, which could increase your total tax liability for 2024 and trigger federal taxes on some or more of your Social Security benefits.

In fact, if your total income exceeds certain levels, upwards of 85% of your Social Security benefits can be subjected to tax. 

Can I Avoid RMDs?

No one likes paying taxes, so naturally many people wonder if there is a way they can avoid RMDs and the taxes that go with them. There is generally just one way to avoid RMDs, and that is to max out your Roth IRA. This is because Roth IRAs trade the short-term tax benefits of IRAs and 401(k)s for permanent tax deferral.

In other words, under current tax law, the IRS is never entitled to a single penny of your Roth account, no matter how large it may get, as long as you avoid withdrawing net proceeds before the age of 59½.

As a result, the government doesn't care about whether or not you actually tap into it for retirement purposes, and there are no RMDs for Roth IRAs. As previously mentioned, upon the death of the original owner of a Roth IRA, the sole beneficiary can cash out the account within five years (still tax-free), or roll the Roth into their own Roth IRA.

It's also possible to roll over some of your traditional IRA into a Roth IRA each year, though only after the age of 59½. And doing so will still incur the same income tax bill since such a move is still considered to increase your adjusted gross income (possibly bumping up your tax bracket if you aren't careful). 

However, this could be a beneficial option for retirees looking to maximize long-term tax benefits in terms of estate planning. Future RMDs will be lowered, the Roth account has no RMDs, and future withdrawals from the Roth account will be tax-free, providing greater flexibility down the road. 

Besides Roth accounts, there is an exception available to delay RMDs for certain employees with 401(k)s. Specifically, if you are still working after age 72, you do not own over 5% of the company, and your company's 401(k) plan does not require payouts, then you do not have to take RMDs from that plan until you actually retire. 

What if you just decide to not do RMDs and avoid paying taxes on them? Or what if you under withdraw (take out less than the full RMD)? Well, that would be a serious mistake.

In fact, one of the harshest tax penalties assessed by the IRS is for not taking and paying taxes on RMDs. Specifically, the penalty is 50% of the difference between your RMD for that year, and what you actually withdrew and paid taxes on.

For example, if your RMD were $50,000 and you didn't withdraw anything, then you would be assessed a $25,000 fine. That means your tax liability would actually increase compared to paying your RMD taxes, since no marginal tax rate is close to 50%.

Simply put, the only safe way to avoid RMDs is by maxing out your Roth IRA over time. Attempting to ignore RMDs is considered tax fraud and will end up costing you much more money over time.

What Should An Investor Do With RMDs They Don't Need?

The IRS doesn't care what you do with RMDs other than pay taxes on them. RMDs are merely designed to let the government recoup the tax-deferred benefits of all retirement accounts except Roth IRAs. It is not uncommon to end up with post-tax RMDs that you don't need for living expenses.

If you are in such a scenario, there are several things you can do with excess RMD cash. The first thing to consider is strengthening your personal finances. If you don't have an emergency fund, or feel its too small, for example, then consider using any excess post-tax RMD funds to increase it.

Another smart thing to do is pay down any debt you have, starting with that which has the highest interest rates such as credit cards. Being debt-free in retirement is a major financial and emotional advantage because it gives you maximum financial flexibility and peace of mind. Especially if any unexpected medical or assisted living expenses should pop up.

Another option is to invest excess RMDs, potentially into a low-risk, high-yield dividend portfolio. Simply Safe Dividends offers numerous quality investment guides including articles that explain how to live off dividends during retirement, and how to build a conservative income portfolio.

If you don't feel comfortable owning stocks, another option is to invest the money into lower-risk bonds. Municipal bond interest payments are tax-free at the federal level, and also at the state level if you live in the state that issued the bonds.

Importantly, you do not have to sell investments in your tax-deferred accounts, transfer the cash to a taxable account, and rebuild part of your portfolio. The IRS allows for "in kind" withdrawals, in which you can have your IRA custodian transfer any securities you own from your IRA and into a taxable account.

The value of the transfer needs to equal the RMD, and you will receive a form 1099-R that reflects the distribution amount, which you owe taxes on (excluding any non-deductible contributions you made). 

This option can be nice to avoid making hard decisions about which investments to sell to raise cash for your RMD. You also avoid incurring extra transaction costs and can reduce the temptation to time the market. 

Just be careful with the amount you transfer since security prices can be volatile; you don't want the market value to fall below your RMD while the transfer request is processed. 

Additionally, make sure you do not end up paying unnecessary taxes on any transferred investments. Their cost basis resets to their market value at the time of the transfer, so any future gain or loss should be calculated using that figure instead of your original cost basis when the investment was held in an IRA. Your holding period also resets, so ideally you can hold these investments for at least a year to qualify for the long-term capital gains tax rate. 

If you want to avoid RMD taxes, an option you can consider is redirecting your RMD income to a qualified charity and thus convert it into a Qualified Charitable Distribution (QCD). This can be highly advantageous because you can avoid RMD taxes and lower your adjusted gross income (AGI) while doing some good for the world.

Most charitable deductions merely lower your taxable income. Lowering your AGI can drop you into a lower tax bracket and thus lower your overall income tax liability. Specifically, it can reduce your tax on net investment income as well as the means-tested portions of Medicare Part B and Part D premiums. For example, currently there is a Medicare High-Income Surcharge on Medicare Part B and D premiums if your single/joint filer AGI is $85,000/$170,000 or above.

However, it's important to note that converting an RMD into a QCD requires having your IRA or 401(k) custodian directly send the RMD to the qualified charity of your choice. There is also a maximum limit of $100,000 per year. For more information about converting RMDs into QCDs, please see the IRS's FAQ page.

Or if you want to be charitable to your own family, then you might consider using excess RMD funds to pay for your grandchildren's education.

Private school tuition isn't considered a taxable gift, and you can also contribute to their 529 (college savings) plan. Funds in a 529 grow tax-deferred (like an IRA), and as long as the money is spent on tuition and other qualified education expenses (books, room and board, etc.), then the deferred tax benefit is permanent. 

Funding a 529 is also a way of reducing the size of your estate and thus can lower any ultimate estate taxes your heirs might owe when you pass on.

If you inherit an IRA, then most of these same options are available to you. However, in that case most financial experts advise prioritizing the following three items:

  • Living expenses
  • Paying down debt
  • Funding a Roth IRA (dividend portfolio or low-cost market index fund)

How To Prepare For RMDs

There are three important ways to prepare for RMDs, with the first two being the most critical for most people.

First, consider whether or not it makes sense for you to potentially withdraw retirement account funds before the 72 age that triggers RMDs. While this won't prevent an income tax bill on the net proceeds (capital gains and accrued dividends), it can give you more control over the timing and size of the annual tax bill.

In addition, by decreasing the size of your retirement account ahead of time you may be able to enjoy smaller RMDs over the long term which might put you in a lower tax bracket. That, in turn, might reduce your overall tax bill.

The second important way to prepare pertains to those who don't need to withdraw from their retirement accounts until age 72 or later. Make sure to run the numbers for your specific situation through the IRS uniform distribution table formula so that you know what your first year's RMDs (and tax bill) will be.  
Don't forget to consider taking the first RMD by the end of the first calendar year to potentially avoid the negative effects of having to take two RMDs in the next year (potentially higher tax bracket).

Finally, if your retirement account is large enough, consider consulting a certified estate planner who can help you decide whether the alternative uses of RMDs (such as charitable contributions or funding your grandchildren's education) might better fit your individual life and financial goals.

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