Planning your retirement income is a multifaceted calculation. One component that may impact your strategy is required minimum distributions (RMDs). These are withdrawals you’re required to take from each of your tax-deferred retirement accounts once you reach age 72. Understanding the RMD rules is essential to crafting an appropriate financial plan for retirement, as they incur taxes and reduce the amount of money you may keep invested in your retirement accounts.
Understanding required minimum distributions
A required minimum distribution, or RMD, is the annual amount that must be withdrawn from certain types of retirement plans starting in the year the account holder turns 72.
According to the IRS, the following types of retirement accounts are subject to required minimum distributions:
- Traditional, SEP, and SIMPLE IRAs
- 401(k), 403(b), and 457(b) plans
- Roth 401(k) plan
- Profit sharing plans
- Other defined contribution plans
Roth IRAs are not subject to required minimum distributions, but inherited Roth IRAs are.
How to calculate required minimum distributions
Retirees must calculate a separate RMD for each eligible account they own. It’s based on the account value on December 31st of the preceding year.
The IRS offers a worksheet for this, or account holders can use an online RMD calculator. Most account holders use the IRS Uniform Lifetime Table to calculate how much they must withdraw each year. The exception is if the IRA owner has a spouse who is the sole account beneficiary and more than 10 years younger—the IRS provides a separate worksheet for them to use.
Here’s how the calculation process works, assuming the spouse beneficiary is not more than 10 years younger than the account holder. The account holder must:
- Find the value of the retirement plan on December 31 of the preceding year.
- Find the distribution period for the account holder’s age (for the birthday they’ll have during the distribution year) on the IRS Uniform Life Table. The distribution period is an important RMD definition to understand because it estimates the remaining years based on the average life expectancy for each age group.
- Divide the account balance by the distribution period to get the RMD for that year.
This process needs to be done separately for each applicable account. Account custodians usually help with this process and must also report the RMD amount to the IRS each year.
Here’s an example: What is the required minimum distribution of a 75-year-old account owner whose IRA account balance is $200,000? The distribution period is 22.9, so the formula would look like this:
$200,000 / 22.9 = $8,733.62
The individual must withdraw at least $8,733.62 during the calendar year as their required minimum distribution.
How are RMDs taxed?
RMDs count towards a retiree’s total taxable income, which impacts one’s tax bracket, and are subject to ordinary income tax at the federal, state, and local levels. That’s because account holders made tax-free contributions over the years, meaning that tax was deferred and must be paid during retirement.
RMDs can be used to make a qualified charitable distribution, or QCD. QCDs are not subject to the annual limit that charitable cash donations are, which is 60% of the individual’s adjusted gross income. Rather, the annual QCD limit is $100,000.
What is the penalty for not taking an RMD?
Not taking out a required minimum distribution by the correct deadline comes with major financial consequences from the IRS. Retirees will owe 50% of whatever portion of the RMD wasn’t taken in a calendar year.
Here’s how that looks using the previous example of a 75-year-old account owner’s $8,733 RMD. If the individual only withdraws $5,000 by the deadline, the remaining balance is $3,733. That amount would be taxed at 50%, resulting in an IRS bill of $1,866.50.
Typically, the deadline to take an RMD is December 31st. However, there’s an exception for the first year when an individual turns 72: They can wait until April 1st of the following year to take the RMD. But they still have to take a second RMD by the end of that year. So one RMD is for their age, 72, and the second one is for age 73.
Another exception for RMDs is for individuals who are still working at age 72, have an employer-sponsored plan, like a 401(k), and don’t own more than 5% of the company. They do not have to take an RMD from the employer-sponsored plan until April 1st in the year following their retirement. They do still have to take RMDs from other eligible accounts, like a traditional IRA.
How do RMDs affect inherited IRAs?
When an individual inherits a traditional IRA, there are several potential treatments for required minimum distributions depending on the relationship with the account owner: a spouse or non-spouse.
Spouses have the most options when it comes to inherited IRA distributions. First, they can roll it into their own existing IRA within 60 days of the distribution. Then they would follow their own RMD schedule when they reach 72 years old.
Otherwise, a surviving spouse can transfer the funds into an inherited IRA. The following RMD rules apply:
- If the account owner was 72 years or older, the spouse must take distributions according to their age and the IRS life expectancy table.
- If the account owner did not reach 72 and had not started taking RMDs, the spouse can wait five years before they’re required to take distributions.
For most non-spouse beneficiaries, the inherited IRA must be distributed by the end of 10 years following the account owner’s death. The distributions are taxable, but the 10% early withdrawal penalty is waived, even if the beneficiary is younger than 59 ½ years old. There are exceptions if the beneficiary falls under one of the following categories:
- An underage child.
- Chronically ill.
- Permanently disabled.
- Not more than 10 years younger than the account owner.
The bottom line
Required minimum distributions are an important component of retirement planning. Once an individual turns 72, the IRS requires them to withdraw a minimum amount from those accounts each year—meaning they’ll incur taxes and have less money to keep in their retirement accounts.