Everything You Need To Know About RMDs

RMDs, or required minimum distributions, are the minimum amount an investor must take out of certain retirement accounts on an annual basis after a certain age. RMDs act as a safeguard for the government for tax purposes.

The accounts that require RMDs offer a tax deferred benefit, meaning that investors do not have to pay taxes on contributions, investment gains, or interest earned until they pull the funds out of the account. If RMDs did not exist, investors would be able to leave these funds in their retirement account(s) indefinitely and avoid taxation.

Think about it like this. The government allows investors to enjoy tax deferred protection in these retirement accounts during the investor's working years. Once the investor wants to access these funds, the government wants to start collecting taxes on the untaxed dollars and hence forces the investor to pull a minimum amount out of their retirement account(s) which is considered taxable income.

Currently, investors are required to start taking RMDs from applicable retirement accounts once they reach age 73. Investors are required to continue to take RMDs from applicable retirement accounts for the remainder of their life

In general, investors must take their RMD before December 31st each year. However, investors are able to delay taking their first RMD until April 1 of the following year. If an investor decides to delay their RMD until April of the following year, they will have to take two RMDs.

For example, say that John is retired and turned 73 in 2024. John decides to wait until 2025 and takes his first RMD before April 1 which is allowed. However, John would also have to take a second RMD later in the year to satisfy his RMD for 2025 as the RMD he took before April satisfied his RMD for 2024.

RMDs are going to apply to almost all retirement accounts that offer a tax deferred benefit. This can include 401(k)s, 457(s), 403(b)s, Traditional IRAs, and SIMPLE and SEP IRAs. RMDs are not required for Roth IRAs as these accounts are funded with after tax dollars - dollars that have already been taxed. Additionally, RMDs are no longer required for Roth 401(k)s starting in 2024 thanks to the passing of the Secure Act 2.0.

RMDs are calculated by dividing your balance from the account at the end of the previous year by a distribution factor. To put it in simpler terms, divide your December 31st account balance by your estimated remaining life expectancy to find your RMD.

The IRS uses what is called the Uniform Lifetime Table and other tables to determine the appropriate distribution factor. Here is an example. Say that Michael is currently 74 years old and is looking to satisfy his RMD requirement for his 401k.

His account balance on December 31st of the previous year was $500,000. His distribution factor would be 25.5. If we divide $500,000 by 25.5 we get $19,607.84. This is the minimum amount that Michael must take out to satisfy his RMD for the current year.

If manually calculating an RMD seems stressful, don't worry. Almost all major financial record keepers that service applicable retirement plans will be able to give you a breakdown of what your RMD will be for each year.

In general, an RMD must be taken for each applicable account. For example, say that you retired and turned 73 with three 401k plans from different employers from your career. An RMD would have to be calculated and taken from each account to satisfy your RMD requirements for the year and subsequent years.

However, there is an exception that exists for two different types of accounts. These two accounts are Traditional IRAs and 403b plans. An RMD can be taken from one of these account types to satisfy the RMD requirement for all of them.

For example, say that you retired with three separate Traditional IRAs with account balances of $1 million, $500,000, and $250,000. If a distribution factor of 25.5 applied, the respective RMDs would be $39,215, $19,607, and $9,803 respectively.

You would be able to pull the total RMD amount of $68,625 from one account as opposed to having to pull the RMD from each account separately. This can give you more control over the RMDs from all accounts. This example would also apply to 403b plans.

RMDs do not have to be taken as a lump sum payment, but you must take the entire RMD by the applicable deadline. For example, say that you had a $10,000 RMD for a 401k plan. You could take this as a lump sum payment at some point during the year, or take smaller payments throughout the year as long as the total sum meets $10,000.

Since RMDs apply to retirement accounts that offer a tax deferred benefit, RMDs are a taxable event. RMDs are considered ordinary income and will hence be taxed at your ordinary income tax rate. Record keepers of employer sponsored plans, such as 401(k)s, will withhold 20% upfront for federal taxes even if your tax rate is lower. Working with a financial advisor and/or a tax professional can help you be prepared for the tax implications of RMDs.

It is vital to meet the RMDs of all of your applicable retirement accounts. Failure to do so can result in the IRS levying a hefty 25% penalty for a missed RMD. This penalty may be lower if you correct it in a timely manner. Regardless, any penalty will eat further into your retirement savings which may affect your spending plan for your accounts.

An RMD is your money so you can use it in almost any way you wish. Most retirees will simply spend their RMD to cover expenses and enjoy retirement. However, you could also save your RMD and reinvest it if you do not need to use the funds immediately.

Some retirees choose this strategy and reinvest the funds into a brokerage account, which can provide a future source of income. Finally, you could gift your RMD through a qualified charitable distribution if you are eligible to do so.