Many types of retirement accounts offer enormous tax advantages. For example, if you make contributions to an IRA or 401k, you may be able to deduct those contributions (i.e., not pay income taxes on the income you use to fund those accounts) now — and, instead, let the money grow — with no taxes due all along the way — until, eventually, usually when you’re retired, you take the money back out.
This “tax-deferred” growth can benefit you in a variety of ways. For example, it lets you rebalance your portfolio any time without tax consequences. It lets you pay taxes at a future tax rate (which, hopefully, may be lower) instead of at today’s tax rate (which may be high because you may be in your highest-earning years). And additionally, money saved for retirement in IRAs and employer-based retirement plans may also be protected in a variety of ways that ordinary investments may not.
However, at some point, the taxes are due. You cannot defer those taxes forever, even if you don’t actually need the money to spend at the moment. And the rules can be quite complex.
Those taxes become due when you take distributions from your accounts. So the government requires, at some point, that you start taking distributions of at least some of the money.
These distributions are called “Required Minimum Distributions” or RMDs. (Sometimes you’ll see them called “Minimum Required Distributions” or MRDs — same thing).
And you’re allowed to take out more. There’s no flag which distinguishes a distribution as an RMD versus any other distribution from your IRA. It’s just that the sum of your distributions over the course of the year needs to exceed that RMD amount. And if you don’t take out enough, the penalties are awful — 50% of the amount by which you were short — plus you’ll still owe taxes.
Finally, remember that “distributions” from a retirement account are simply withdrawals. Even if you’re required to take those distributions, you’re not forced to spend them. Other than the taxes, RMDs are not necessarily all that bad.
To start with the most simple case, if you’ve put pre-tax money into your own IRA, starting in the year in which you turn 70-1/2 (really!), you need to take taxable distributions. The computation of how much you need to withdraw (and pay taxes on) is based on your life expectancy, and on the balance of your IRA at the end of the previous year.
So, for example, if you turned 75 in 2015, and your IRA had a total balance of $100,000 on Dec 31, 2014, you look up your age in the IRS’s “Uniform Lifetime Table” and find that the “divisor” you use — based on your life expectancy — is 22.9 (years). So by the end of 2015, you need to take a taxable distribution of $4,366.81.
There are some caveats. (a) it may not be entirely taxable — if you’d put non-deductible contributions into your IRA, it may be only partially taxable; (b) if you’re married and your spouse is the sole beneficiary, and your spouse is more than 10 years younger than you, you may be eligible to use a joint life table which spreads the distributions out over a longer period of time (meaning you may take out less right now); and (c) if you have other IRA accounts, you may be able to aggregate the distributions rather than take distributions from each account.
You generally do not have to take RMDs from a Roth IRA.
Employer-based plan (401k, 403b, etc)
These are usually similar to IRAs, though if you have Roth accounts in your 401k, you may be subject to RMDs on it, too. You can sometimes avoid RMDs from employer-based plans, though. For example, if you’re still working for that employer, you don’t need to take RMDs from that employer’s 401k. And if you have a Roth account in your 401k and don’t want to take RMDs from it (i.e., again, you don’t need the money right now), you can roll over the balance into an IRA and the rollover Roth IRA, as noted above won’t have RMDs.
There may be some additional complexity in that employer plans often cannot have the RMDs aggregated. So, unlike IRAs — where if you have multiple IRA accounts, you can simply add up the RMDs and take it all from any combination of those accounts — with 401k plans, each plan needs to make RMDs individually. (Other employer-based plans such as 403b plans also have different rules). Check with each individual plan sponsor to make sure you are complying with their rules.
One more thing — if you are already subject to RMDs (i.e., usually, if you’re over 70-1/2 and no longer working for that employer) — and you plan on rolling over your employer-based plan balance into an IRA — make sure to take the RMDs from that account before the rest of the account is rolled over. The plan provider should make sure this is done, but if they don’t — and the full balance without having had RMDs taken out gets rolled into an IRA — it’s extremely messy to undo. So if you’re subject to RMDs and doing a rollover, check and double-check that this is handled correctly.
And those are the simple cases. It gets much more messy if you’ve inherited an IRA or employer-based plan. The rules for inherited retirement accounts are more complex than those listed above, and the mechanics and calculations depend on multiple factors such as whether you’ve inherited the account from a spouse or from someone else (a parent, for example). And whether the person you’ve inherited the account from was already taking RMDs when he or she died or not. And, of course, whether it’s an employer-based plan or not. And finally, the distribution rules may offer a few options (i.e., take it all at once, take it within 5 years of the death, or — often most favorable tax-wise, but potentially very much more complicated, “stretch” the distributions out over the life expectancy of beneficiary (rather than the original owner) of the account.
And unlike a Roth account of your own, an inherited Roth IRA is also subject to RMDs just like any other inherited IRA. When Roth accounts (either employer-based or Roth IRAs) are subject to RMDs, the money does need to come out of the accounts but generally those Roth distributions are still tax-free.
Can you avoid RMDs?
It depends on all the factors listed above. Generally, if you don’t need the money right away, the longer you can let it remain in retirement accounts, the better, so if you can avoid or minimize RMDs, that’s great. A few ways to minimize them include: (a) doing Roth conversions — moving money from a pre-tax IRA into a Roth IRA — which may require paying taxes now in lieu of paying them later — but if you’re in a lower bracket now, that can make enormous sense; (b) continuing working for your employer (and potentially rolling over money from other former employer plans into your current employer’s plan); (c) optimizing your investments — the “growthiest” investments may be in Roth accounts on which RMDs won’t be due and the less “growthy” investments may be placed in the traditional pre-tax accounts;
[One more way to lower your RMDs may be to marry someone a lot younger than you… 🙂 ]
Can the whole thing be made easier?
Most custodians (such as Fidelity, Vanguard, etc) are very happy to help make your RMDs as simple as possible to deal with. For IRAs, they are all required to file and send you a copy of an IRS form (5498) every year which lists what the year-end balance was, and usually includes a flag indicating whether you are subject to RMDs on that account. They’ll usually also compute those RMDs for you (as a convenience – it’s still up to you to make sure the computation is right — they may not know about things like whether you are aggregating your distributions, or if you’re able to use other rules).
And especially convenient, the custodians almost all offer an “automated” RMD service wherein they (perhaps with your help/input at the beginning of the year) will automatically send you your RMDs on a schedule — which may be monthly, quarterly, or annually. The automated plan is especially convenient for employer-based plans where each plan needs to send the RMDs individually anyway. And if you have both a retirement account and a taxable account at the custodian in question, they’ll usually be happy to simply transfer the money from the retirement account into the taxable account rather than send you a check.
Finally, all the custodians are required to offer you the opportunity to have federal and/or state income taxes withheld. If you’re getting substantial distributions, this may be a lot more convenient than (or a nice complement to) doing quarterly estimated taxes.
If you are subject to RMDs — or if you’re not sure whether or not you are! — and have any questions about it, please contact your trusted professional, and soon. The penalties for making mistakes are potentially enormous (again, up to 50% of the missed RMD), and the rules can be complex. If you’re over 70, or you’ve inherited an IRA or other retirement plan, this means you!
[Nothing in this article should be construed as tax advice. Contact a qualified tax professional to discuss the tax implications involved in taking Required Minimum Distributions from your retirement plan as well as any other tax matters relating to your retirement plan options.]