IRS requirements around when to take required minimum distributions have changed. Planning your RMD strategy early could help you protect your assets and reduce your tax liability.
If you are age 60 or above and have an IRA, 401(k) or other retirement plan, you need to start thinking about required minimum distributions.
Managing your required minimum distributions incorrectly can cost you money. It might even cause you to burn through your retirement savings too quickly.
As with a lot of financial matters, it helps to plan ahead rather than wait until you have to make a decision.
Depending on your comfort with financial concepts, you may choose to do this planning yourself or with the help of a professional financial advisor. Either way, knowing the basics can help you prepare.
Important note for 2020: This article discusses general rules for how required minimum distributions work, but the CARES Act that was passed in response to the coronavirus outbreak suspended the necessity of taking these distributions in 2020.
What is a Required Minimum Distribution (RMD)?
A required minimum distribution (RMD) is the minimum amount someone who owns a retirement plan account must withdraw every year starting with the year that he or she reaches 72 (or 70 ½ if they reached age 70 ½ before January 1, 2020). If the account holder keeps working beyond that age, RMDs kick in the year in which he or she retires.
That's because participating in a retirement plan typically comes with tax breaks. When it comes to 401(k)s or traditional IRAs, those tax breaks take the form of getting to delay when you pay taxes on the money you put into those plans.
This tax break is intended only to let you delay taxation. It does not make the money tax-free forever.
So, while you don't have to pay taxes on money when it first goes into a 401(k) or a traditional IRA, you are supposed to start paying taxes on that money eventually. That's where required minimum distributions, or RMDs, come in.
RMDs dictate when and how much you have to start withdrawing from your retirement plan. Since withdrawals from 401(k)s and traditional IRAs are taxable, RMDs regulate when you have to pay tax on the money that was shielded from taxes going into your retirement plan.
>> Read guidance on official IRS site: Retirement Plan and IRA Required Minimum Distributions FAQs
How RMD rules changed due to SECURE Act
Prior to the year 2020, people with money in 401(k)s or traditional IRAs were required to start taking RMDs once they reached age 70 1/2. Thanks to the Setting Every Community Up for Retirement Enhancement (SECURE) Act, however, if you reach that age in 2020 or later, you can wait until you turn 72 to start taking RMDs.
What determines how much to withdraw
The amount of the RMD you have to take is determined by an IRS table based on your life expectancy. If you have a spouse who is the sole beneficiary of your IRA and is at least 10 years younger than you, your RMDs can be taken over a longer period of time using a different IRS table.
Remember, the word "minimum" is a key part of RMD: It is a minimum requirement, but you can take more than that out of the plan if need be.
In any case, your RMD is taxable as ordinary income in the tax year for which the RMD is taken. If you fail to take the necessary RMD, the penalty is steep - a 50% tax penalty.
How Do I Calculate My Required Minimum Distribution?
There are three ways to calculate your required minimum distribution, depending on your individual situation:
- If you are a beneficiary who has inherited an IRA
- If you are married to a spouse who is more than 10 years younger than you and is the sole beneficiary of the plan
- If you are a) single or b) married to someone who is not more than 10 years younger than you or c) you are married but your spouse is not the sole beneficiary of your IRA
Each of these calculation methods is described below.
Note: These are just general descriptions. There are many variables in each case, so you should check the latest version of IRS Publication 590 for more details. If you are at all unclear about which calculation method applies to you, consult a tax advisor.
1. How do I calculate my minimum distribution if I am a beneficiary who has inherited an IRA?
If the original owner of the IRA died before having to take minimum distributions, you would not have to start taking RMDs until the year when the original owner would have reached the age where those distributions were required.
If the owner had already reached the age when RMDs were necessary, you would have to start taking RMDs immediately.
In either case, once you start taking RMDs, the amount of those RMDs is based on your remaining life expectancy. Table I of IRS Publication 590 shows the remaining life expectancy of people aged from 0 to 111 years.
To calculate your RMD, match the remaining life expectancy from Table I with your age. Then take the market value of the IRA at the previous year end, and divide that market value by your remaining life expectancy.
The result is the amount of the RMD you must take that year.
Here's an example: You have inherited an IRA and are required to take minimum distributions from it. The market value of the IRA last December 31 was $400,000. You are 50 years old.
According to IRS Table I, the remaining life expectancy at age 50 is 34.2 years. To calculate your RMD for this year, divide the $400,000 market value by 34.2.
The result is $11,695.91. That is the amount of the minimum distribution you must take this year.
2. How do I calculate my minimum distribution if I am married to someone more than 10 years younger than me who is the sole beneficiary of the plan?
In this case, the RMD amounts are designed to provide both for you and for your spouse over your respective life spans. Thus the RMDs are based on a blended amount of your age and your spouse's age.
This blending of the IRA owner's age with that of a younger spouse slows down the pace of RMDs, making the money in the IRA last longer.
Table II of IRS Publication 590 shows this type of blended distribution period.
Table II has a list of ages along the top, and a list of ages along the left side. The body of the chart shows a variety of distribution periods based on the combined ages.
Look for your age in the column down the left side and your spouse's age in the row along the top. The intersection point between these two ages is the period you must use to calculate your RMD for that year.
Divide the market value of your IRA as of December 31 of the previous year by the distribution period from Table II. The result is your RMD amount for this year.
Here's an example: Suppose you are aged 80, and your spouse is 65. The market value of your IRA last December 31 was $400,000.
On IRS Table II, the intersection of ages 80 and 65 shows a distribution period of 22.1 years. To calculate your RMD for this year, divide the $400,000 market value by 22.1.
The result is $18,099.55. That is the amount of the minimum distribution you must take this year.
3. How do I calculate my minimum distribution if I am single, or my spouse is not more than 10 years younger or someone other than my spouse is a beneficiary?
In this situation, RMDs are designed to draw down the money in your retirement plan gradually enough to last for the rest of your life.
Table III of IRS Publication 590 shows distribution periods for this situation. Look up the distribution period listed alongside your age on Table III.
Divide the market value of the IRA as of December 31 of last year by that distribution period. The result is your RMD for this year.
Here's an example: Suppose you are aged 80 and unmarried. The market value of your IRA last December 31 was $400,000.
The distribution period shown on Table III for an 80 year old is 18.7 years. To calculate your RMD for this year, divide the $400,000 market value by 18.7.
The result is $21,390.37. That is the amount of the minimum distribution you must take this year.
Plan RMDs Long Before You Turn 72
Required minimum distributions are a tax necessity but not a financial planning tool.
To figure out how to make your retirement money last and try to manage your tax liability, it's a good idea to do some long-term planning long before you reach age 72.
A financial or tax advisor can help you figure out how to fit your RMDs into a plan for how your retirement savings can meet your needs throughout retirement.
Different scenarios can affect your plan
While the idea behind RMDs is to have you steadily take money out of your retirement plan over the remainder of your life from age 72 onward, RMDs are not always a good guide to how quickly you should draw down your retirement savings.
For one thing, you don't have to wait until you've reached age 72 to start taking money out of your retirement plan. You can do that without penalty any time after you reach 59 1/2.
These situations and factors could affect how and when you withdraw from your retirement account:
- Need to withdraw early
As a practical matter, many people can't afford to wait until they turn 72 to start drawing on their retirement savings. People in that situation need to figure out a schedule of withdrawals that starts earlier yet lasts long enough to meet their needs.
- Tax considerations
There may be tax reasons for starting to take money out of a retirement plan before you turn 72 also. For example, withdrawals from retirement accounts are treated as ordinary income, so larger withdrawals can push you into a higher tax bracket.
You can make smaller annual withdrawals to keep yourself in a lower tax bracket if you start taking money out of your retirement plan earlier. You have to weigh the trade-off between paying tax at a lower rate sooner as opposed to paying tax at a higher rate once you start taking RMDs.
- Annual spending needs change
On top of the tax implications, the simple fact is that RMDs won't always match your annual spending needs. They may be more than you need, or you may need to take out more than the RMD amount.
Should You Spend Your RMDs?
One reason for doing some long-term planning is that, while RMDs are designed to draw down a retirement plan over your remaining life, the amount of those RMDs may vary from year to year.
Market fluctuations and uncertainty about how long you will live are two reasons the amount of RMDs may vary.
Because of this, you should set a spending budget that isn't solely based on the amount of your RMDs. Spending less than your RMD will allow you to save some money for later years when your RMD may not meet your needs.
Even though you will no longer receive the tax benefit of a retirement plan on money you take in an RMD, you shouldn't feel compelled to spend it all. You should plan for how saving some of that money in a taxable account may help you meet future needs.
What to Do with Excess RMD Amounts
Let's say you find yourself taking an RMD amount that is more than you need to spend that year. What should you do with the extra money?
If your needs are uncertain or you anticipate you'll need the money within a few years, you should put it in a safe and stable investment vehicle like a savings account or a certificate of deposit (CD). In fact, CDs can be especially useful for making money available when you plan to need it while earning a better yield in the meantime.
If you don't anticipate you'll need some of that money for several years, you might even invest some of it in growth instruments like stocks. This growth element carries some risk, but it may also help counteract the effect of inflation.
Knowing how much to spend and when you may need any excess RMD amounts in the future should be part of your long-term plan.
That's another reason why you should work out that kind of plan either by yourself or working with a professional advisor well before you start taking RMDs.