In qualified accounts, like TSP, a 401(k) or an IRA, investment returns can compound over time without any erosion from current income taxes. Contributing to these accounts during your working years may result in a pretty sizable nest egg. If you do this for many years, these assets may allow you to finance consumption goals for decades in retirement. So, a key component of retirement planning is understanding how and when to take distributions from qualified accounts. At a certain point withdrawals become mandatory. Factoring Required Minimum Distributions (RMD) into your plan can help you optimize your retirement cash flow.
Why Planning for RMDs is so Important
Retirement is a primary concern for many people. Not knowing if you’ll have enough money to last throughout retirement can be unsettling. The thought of burdening family because you don’t can be even more so. This is why planning is so important.
Saving money in qualified retirement accounts is the first part of such a plan. The second part is timing your withdrawals from those accounts as efficiently as possible. Distributions from qualified accounts are generally taxable. That isn’t problematic. But taking them before they become required might be.
For example, depleting a qualified account early in retirement reduces its primary benefit – its tax deferral. The longer you can postpone distributions, the longer you can delay those taxes. Depending on your age, just because you’re retired doesn’t mean you have to make withdrawals from qualified accounts…at least until they become mandatory.
This is why many investors live off of their taxable accounts early in retirement. It can be more tax efficient for them to consume these assets first. This allows qualified accounts to continue to grow without creating incremental taxable income.
A second benefit of delaying distributions from retirement accounts is that they can affect Social Security benefits. Taxable income over a set ceiling can subject a portion of your Social Security benefits to income tax. Higher income taxpayers also pay higher Medicare premiums.
When RMDs Will Impact You
While postponing withdrawals from qualified accounts is a straightforward retirement planning concept, it is somewhat complicated by the rules around required minimum distributions.
Tax rules establish that you must take an RMD out of your retirement accounts starting the year you reach either 70 ½ or 72.
- If your age prior to January 1, 2020 was 70 ½, then the year you reached 70 ½ is when you should have taken your first RMD.
- If you attain age 70 ½ on or after January 1, 2020, then your RMD must begin the year you reach age 72.
- RMDs must be taken by April 1st of the year after you reach 70 ½ or 72, as applicable. For subsequent years that you are required to take an RMD, you must take your RMD by December 31st.
Distributions from your accounts are not required prior to this. But when they are, calculating your RMD can be complicated.
How is an RMD Calculated?
Your annual required minimum distribution is derived by dividing the total balance of all of your retirement accounts as of December 31st of the preceding year by a “distribution period” number provided by the IRS.1
The IRS provides distribution period tables online. But calculating RMD can be complicated. Working with your accountant and a professional financial advisor can make the process less stressful.
When are Taxes on RMDs Due?
Understanding when taxes are due on your required minimum distributions is also important. There are separate the steps in the timeline. That timeline unfolds over three years.
Year One: Calculate RMD based on yearend balances.
Year Two: Withdraw funds from your retirement accounts. They become taxable income.
Year Three: Pay any tax liability your RMD created in Year Two.
You can delay your first RMD until April 1st of the year following the year you reach either age 70 ½ or age 72, as applicable, but then you will be required to take two RMDs that year.
Recent Changes to RMD Rules
There have recently been two changes to the required minimum distribution rules.
The first change took place in 2019 under the Setting Every Community Up for Retirement Enhancement, or SECURE, Act.
The SECURE Act increased the age threshold for taking RMDs to age 72 for IRA account owners reaching age 70 ½ on or after January 1, 2020. This does not affect individuals who reached age 70 ½ prior to January 1, 2020. For those individuals, distributions from retirement plans and IRAs must generally begin no later than April 1st of the year following the year in which they attain age 70 ½.
Prior to the enactment of the SECURE Act, anyone who reached age 70 ½ had to start taking RMDs. As stated above, beginning in 2020, those who reach 70 ½ on or after January 1, 2020 don’t have to start taking RMDs until they reach age 72.
The second change to RMD rules came in 2020 with the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
This CARES Act temporarily waived RMDs due in 2020 for those who were obligated to take them. This temporary waiver applies to several types of retirement plans including IRAs, 403(b) plans, tax-qualified defined contribution plans, (e.g., 401(k)s and profit sharing plans), and 457 government plans. The waiver also applies to persons reaching age 70 ½ in 2019 who delayed taking their first RMD until April 1, 2020.
This CARES Act allowed those who had already taken an RMD in 2020 to return the funds to the original or another IRA or qualified plan account by the later of 60 days after the RMD was received or August 31, 2020.
Understanding how these changes have affected RMDs is important. RMDs have not been waived indefinitely. So, planning remains very important. Going forward, you won’t avoid taxes if you forget to take your RMD. In fact, you’ll be penalized!
Those who forget to take their required minimum distribution are subject to a tax of up to 50 percent of what that RMD would have been. So, if your RMD was $50,000, the penalty for not withdrawing it could be as high as $25,000. The same 50 percent penalty rate applies if you withdraw less than the minimum.
What to Consider Before Taking RMDs
There have been some recent changes to the required minimum distribution rules. Some were just temporary because of the coronavirus pandemic. Some are still in effect.
The timing of RMDs (from age 70 ½ to 72) are the result of changes that went into effect in 2019 because of the Setting Every Community Up for Retirement Enhancement (SECURE) Act. They are still in place today.
Temporary changes that went into effect in 2020 as a result of the Coronavirus Aid, Relief, and Economic Security (CARES) Act are no longer in place. So, be careful. The most significant temporary change was that RMDs were waived in 2020. They aren’t waived any more. You have to take them.
RMDs were waived in 2020. But not after that. So, planning remains very important. You must take the distribution to avoid tax penalties. And they are huge!
Those who forget to take their required minimum distribution are subject to a tax of 50 percent of what that RMD would have been. So, if your RMD was $50,000, the penalty for not withdrawing it is $25,000. The same 50 percent penalty rate applies if you withdraw less than the minimum.
1 See IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs).