What is a required minimum distribution and how can this caveat help you save more for retirement?
Disclaimer: The information provided is not intended as tax or legal advice and may not be relied on for purposes of avoiding any federal tax penalties. Individuals are encouraged to seek specific advice from their personal tax or legal counsel.
Having a solid plan in place to enjoy our golden years is something that demands a lot of time and commitment decades before we’re even reaping the benefits of our diligence. It requires a lot of thought, budgeting, investing, and consistency to master. A well-built nest egg is not something you just stumble into.
Of course, there are a lot of I’s to dot and T’s to cross in order to avoid any missteps along the way, and to follow your plan successfully.
One of the most often overlooked aspects of those details is required minimum distributions, or RMDs. RMDs are a must-know principle of retirement investing, and something to plan for long before reaching the point where you’ve got to start withdrawing.
The story of RMDs
Most retirement accounts (aside from their Roth IRA relative) are tax-deferred accounts, meaning your contributions go into the account tax-free every year, and you’ll owe those taxes upon withdrawal in retirement.
Because of this, the IRS wants to protect itself against a potential loophole. Suppose an account holder elected to never withdraw from their tax-deferred retirement account. In that case, they could theoretically never pay any taxes on their assets before passing it on to their heirs.
As a result, the IRS created the required minimum distribution in lockstep with these tax-advantaged accounts to prevent that from happening.
Details of the RMD rule
When: Currently, accountholders must begin taking their RMDs in the year that they reach age 72, and there is the potential for this number to increase pending legislation
How much: The amount you’re required to withdraw annually is calculated by accounting for your date of birth, account balance, and the life expectancy factor, which is a number ranging from 27.4 at age 72 to 2.0 at age 120. For example, a 72-year-old with an investment value of $200K at the end of 2021 would be required to withdraw $7,299.27 in 2022 to meet their RMD requirements.
The method: You can withdraw your RMD in any fashion you choose, whether a lump sum payout or consistent deposits throughout the year. If you have multiple retirement accounts that require an RMD, the way you structure your withdrawals depends on the account type. If you own multiple IRAs, for example, the withdrawal can come from just one account to cover the total obligation; however, for 401(k)s, the withdrawal must come separately from each account.
Penalties: Failure to take your RMD will result in a 50% tax penalty of the amount you were required to withdraw. Missing that $7,299.27 withdrawal in our example scenario would trigger a $3,650 penalty. A little planning can help you avoid this nuisance.
Account types: Essentially all employee-sponsored retirement accounts, and IRAs, are subject to the RMD rule—even the Roth 401(k) doesn’t escape. If you want to avoid the RMD liability entirely, a Roth IRA is your safe haven.
How RMDs impact your retirement
How does the RMD rule play into your retirement planning? Well, that depends a lot on your situation. If you’re like most retirees and plan to at least somewhat rely on your retirement accounts for income, then RMDs will likely be a non-issue for you.
However, if you’ve done exceedingly well at saving for retirement and have several accounts stuffed to the brim, then RMDs will be a part of your retirement reality.
Fortunately, RMDs aren’t too difficult to handle. All you’ll need to do is ensure you accurately calculate how much you’ll be required to withdraw annually once you reach that golden age, and then execute the withdrawal one time every year—maybe even a little less than every 12 months, just to be safe.
Minimizing an RMD impact
If you still want to minimize the impact RMDs have on your retirement savings, you have a couple of options.
Convert to a Roth IRA
Converting your account to a Roth IRA will trigger a tax bill on the conversion, but any gains or withdrawals after the fact will continue to grow tax, hassle, and RMD-free. This can make a ton of sense if you are doing the conversion in a year where you have an exceptionally low tax bracket.
Donate the RMD to charity
If you’re in a position where you have to take RMDs, there’s a good chance you don’t need the money. If that’s your situation, donating your RMD to charity (up to $100,000) can help offset your overall tax obligation for the year, easing the blow of the taxes owed on that withdrawal.
Sell select holdings
If you complete your RMD automatically, as many people do, you could end up having to sell assets you don’t want to sell, to be able to fund your withdrawals. By going for the manual process, you can choose to sell less of your better-performing assets, and maybe even pull entirely from cash if your account's assets hold enough to cover it.
Planning is key
Ultimately, the key to successfully navigating the world of RMDs and using them to your advantage comes from planning ahead. It’s never too early to start thinking about the future, and the younger you get started on a retirement plan the better.
Once you have a good idea of where you’ll financially be as you near retirement, you can begin budgeting and taking actionable steps to plan for your RMDs, and potentially avoid or minimize the impact those taxes have on your investments — allowing you to keep more money in the markets for longer.
People don’t just read about RMDs for fun, so the fact that you’re here indicates you’re well on your way to financial wellness. But that doesn’t mean there’s not always room to improve, right? This is your friendly reminder to keep a check on your to-do list items in your app, review your transactions, and peep your cashflow—it’ll only take 3 minutes each week!