During your working years, you may be saving money into a retirement account at work, such as a 401k plan. Contributing pre-tax money to a tax-deferred account like a 401k, allows you to defer the taxes that would be due on the money you put in. These contributions are allowed to grow tax-free until the money is taken out. The catch is the IRS only lets you defer the tax for so long.
At age 70½ the IRS requires you to start taking Required Minimum Distributions (RMD) from your retirement accounts. Here is what you need to know about RMDs and how to get ready to take your first one.
What is an RMD?
The IRS RMD rule requires you to start taking pre-tax money out of tax-deferred status at age 70½ so that the IRS can ensure it will begin collecting the taxes due. The purpose of RMDs is not to allow individuals, who may never need the money in their retirement accounts, to be able to pass on these accounts for generations and enable the deferral for extended periods without it being taxed.
Each year, after you turn age 70½, your RMD is required. You must take out at least the RMD total from your retirement accounts, or you will incur a stiff penalty for the failure to take your RMD. When an RMD is not correctly taken, any shortfall is subject to a 50% penalty. You can always take out more than your RMD without penalty, but the additional amount does not count towards your next year's RMD. Taking more out than required can reduce the account value and reduce your next RMD, but you will still have to make the subsequent necessary withdrawal unless your account value is $0.
The total withdrawals from your retirement accounts will be considered ordinary income (unless after-tax dollars were contributed to the pre-tax account). The ordinary income withdrawals will be added to your taxable income for the year it is distributed and taxed at ordinary income tax rates.
Depending on the size of your pre-tax retirement accounts, your RMDs can be very substantial and can push retirees into the higher tax brackets. Always work with a CFP® or Tax Preparer (CPA or EA) to see what strategies you should be taking advantage of to manage the tax hit of your RMD.
What accounts require an RMD?
If you have any of these account types, the required minimum distribution rules apply for each account:
profit sharing plans
other defined contribution plans
Roth IRAs do not require withdrawals until after the death of the account owner. Beneficiaries of Roth IRA's will need to take RMDs once the account is inherited. Other rules, not covered here, apply to inherited accounts with RMDs.
How do I calculate my RMD?
The custodian who holds your retirement accounts should calculate your RMDs for you, but the account owner is ultimately responsible for the correct calculation and distribution of their RMD. You can easily calculate the RMD yourself, here's how.
To calculate your RMD, you will need to know two things:
The value of your retirement account on December 31st of the year before the year you need to take the RMD. For example, if you turn 70½ in 2019, then your 2019 RMD would be based on the account value on December 31st of 2018.
The difference in age between you and the primary beneficiary of your account. If married, the beneficiary is most often your spouse. If your beneficiary is older or 1-9 years younger than you, you will use the Uniform Lifetime Table. If your beneficiary is more than 10 years younger than you, you will need to use Table II (Joint Life and Last Survivor Expectancy). On either table, you will need to find the distribution period associated with your age.
The RMD is calculated by taking the prior year-end value and dividing it by the distribution period from the correct Lifetime table.
Example: If you turn 70½ in 2019 and the 12/31/2018 value of your retirement account was $100,000 and your beneficiary is a spouse 3 years younger than you, then your 2019 distribution would be $3,650 (100,000/27.4).
If you need more guidance on calculating your RMD, the IRS provides these worksheets to help you calculate the correct amount.
When do I have to take my first RMD?
Your first RMD must be taken by April 1st of the year following the date you turn 70½. Each year after the first year, you must take your RMD by December 31st of the year your RMD is due. The first year is the only year this special rule applies.
For example, if you reach age 70½ on June 1, 2019, you can delay your 2019 RMD until April 1, 2020, at the latest. Then, your 2020 RMD must be taken by December 31, 2020. If you do not want to use the special rule for the first year, you must receive the RMD for 2019 by December 31, 2019. In the first year, you are allowed to delay your RMD income, but then you must double up on your RMD income in the year following.
If you are working at age 70½ and still contributing to a pre-tax defined contribution plan you can delay your first RMD until you retire, unless you are a 5%, or more, owner of the company in which you are employed.
What should I do with the money?
So, the IRS requires you to take this money out of tax-deferred status, but what does that mean you should do with the money? Depending on your situation there are many options. If you are in a portfolio withdrawal phase, you are actively pulling from your retirement accounts to pay for your living expenses; then you might take out the money to cover your regular expenses. Other ideas could be to funnel the money into a Brokerage account or do a Qualified Charitable Distribution (QCD). We wrote about using the QCD strategy in a previous post, read it here.
There are many financial planning strategies for when to take your first RMD, managing the RMD tax bill and how to use the income. A financial planner can help you review all the strategies related to your RMD's. Though, many strategies take place during the years prior to your first RMD, so don't wait to reach out and get help.
Alicia Butera, CFP® is a Financial Planner for Planning Within Reach, LLC (PWR) located in Scripps Ranch, San Diego, CA. Alicia is the Director of Financial Planning and Marketing for PWR. Alicia manages the financial planning process from start to finish with her clients, answering their questions and providing them guidance. Alicia has 8 years of experience in wealth management and works virtually with clients all over the US.
Planning Within Reach, LLC (PWR) is a fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services in San Diego, CA. PWR is a virtual firm that is woman-owned and serves busy families and impact investors. Planning Within Reach, LLC and their advisors never receive any type of commissions for sales and does not have any insurance licenses or brokerage relationships.