One way to save for retirement is by contributing money to a tax-deferred investment account, like an individual retirement account (IRA) or employer-sponsored 401(k).
You won’t pay income tax on the money you put into these accounts until you withdraw it. That means you get to defer paying taxes on the money you put in, and on the growth.
Of course, the U.S. government wants to make sure those taxes aren’t deferred indefinitely. That’s where required minimum distributions (RMD) come in.
To avoid costly penalties, it’s important to understand what an RMD is, when you need to take your RMD, and how RMDs are calculated. Plus, there are some optimal distribution strategies that can help you maximize your earnings and minimize your lifetime taxation.
What is an RMD?
A required minimum distribution (RMD) is the amount of money the IRS requires you to withdraw from certain retirement accounts in a given year.
Most retirement accounts allow you to make tax-deferred contributions. Later on — most likely in retirement — your distributions from these accounts, including your RMDs, become taxable income.
RMDs are a way for the government to receive the tax revenue you’ve been deferring on these pre-tax contributions, instead of deferring those taxes indefinitely.
Who has to take RMDs?
The primary factors that determine whether or not you have to take an RMD are:
- Account type
- Employment status
Age of account owner
As of 2022, account owners must start taking RMDs by April 1 following the year they reach 72 (prior to 2020, the starting age for RMDs was 70½). So, if you turn 72 any time in 2022, you would be required to take your first RMD by April 1, 2023. All subsequent RMDs must be taken by December 31 each year.
It’s worth noting that if you delay your initial RMD until the year after you turn 72 (i.e., between January 1 and April 1 the following year), you will be required to satisfy the previous year’s RMD (by April 1) plus the current year’s RMD (by December 31). Taking two RMDs in the same year could have significant tax consequences, which is why we typically recommend taking your initial RMD in the same year you turn 72.
RMDs apply to traditional and rollover IRAs, as well as employer-sponsored retirement plans, including:
- Traditional 401(k)
- Profit-sharing plans
- Roth 401(k)
- SIMPLE IRA
- SEP IRA
RMDs do not apply to Roth IRAs while the account owner is still alive.
If you have multiple accounts with RMDs, you must calculate and satisfy RMDs for each of them. If you have multiple IRAs, you can withdraw the total amount from a single IRA (if you choose). However, RMDs for employer-sponsored plans must be taken from those specific accounts.
If you’re 72 years of age or older and still working, you can delay taking your RMD for your active employer-sponsored account. You’ll still be required to satisfy RMDs for employer-sponsored accounts from previous jobs, as well as your IRAs.
You won’t be required to start taking RMDs from your current employer’s plan until you retire.
There is a caveat: If you or one of your immediate family members owns 5% or more of the company you’re working for, you still have to start taking RMDs at age 72.
How much is an RMD?
Determining your required minimum distribution may sound more complicated than it actually is.
Using a basic formula provided by the IRS, here’s how your RMD is calculated:
Prior Year-End Fair Market Value of Account ÷ Your Life Expectancy Factor = RMD
The first part of the calculation is fairly straightforward. You just need to find the year-end value of your account from the most recent year. You can usually find this on your account statement.
The second part of the equation — your “life expectancy factor” — is determined and published by the IRS each year. It’s important to note that these can (and often do) change from year-to-year, so you want to make sure you’re referencing the right life expectancy tables when calculating your RMD.
- The most common life expectancy table is the Uniform Lifetime Table.
- If your spouse is more than 10 years younger than you and is the sole beneficiary of your account, you should use the Joint Life Expectancy Table.
So, let’s assume:
- You are 80 years old, and your spouse is 78
- As of December 31, 2021, your IRA balance was $500,000
Your RMD for 2022 is:
$500,000 ÷ 20.2 (Life Expectancy Factor) = $24,752.48
As a reminder, if you have multiple accounts that are subject to RMDs, you’ll need to use the above formula to calculate the RMD for each account separately.
To make the calculation easier, you can use a free RMD calculator. Here’s one from Charles Schwab.
Looking at the formula used to calculate RMDs, you’ll see that the two biggest factors are your account balance and age. All things equal, as your account balance goes down, so does your annual RMD. But, all things equal, as you get older, your annual RMD gets higher.
So, you may be wondering if you can take more than the required minimum distribution amount to reduce future RMDs. The answer is yes. You can take out more than the required minimum, but it’s important to keep in mind that the total amount of each distribution — not just the RMD amount — is considered taxable income.
When do RMDs have to be taken by?
Your first RMD must be taken by April 1 of the year after your turn 72. For example, if you turn 72 in November of 2022, the deadline for your first RMD is April 1, 2023.
The deadline for your following RMDs — that is after your first one — is December 31 each year.
It is important to know that if you delay taking your first RMD until April 1 of the year after you turn 72 (which is allowed), you’ll still be required to take another RMD by December 31 of the same year. Both of those distributions will be considered taxable income, which could result in a hefty tax bill and put you in a higher tax bracket. For this reason, we almost always recommend taking your first RMD during the year in which you turn 72 instead of delaying it to the next year.
If you fail to take your RMD by the required deadline, the IRS may penalize you with a fee up to 50% of the amount you failed to withdraw. For example, if your RMD is $20,000 but you only took $10,000, you’ll be assessed a $5,000 penalty — and still be required to withdraw the remaining $10,000 of your RMD.
How do RMDs affect your taxes?
When RMDs are taken, you’ll pay ordinary income taxes on those (and any other) distributions from pre-tax accounts. Based on your income, your RMD could potentially put you in a higher tax bracket.
Tax brackets are important, particularly for retirees. That’s because your tax bracket can have ripple effects on the taxes you pay on Social Security income and Medicare Part B premiums.
For this reason, retirement tax planning is a major component of your overall financial plan. If you don’t consider all of the variables, you could end up spending more of your retirement savings on taxes.
Planning strategies for your RMD
RMDs can impact everything from the current year’s tax bill to the taxes you pay on Social Security. Most Americans need their full RMD to cover their living expenses. However, if you don’t actually need your RMD in a given year, there are some strategies to keep in mind to minimize your taxes.
Qualified charitable distributions
If you’re a charitably inclined investor, qualified charitable distributions (QCDs) are a great tool for lowering your tax bill and maximizing the value of your contributions. QCDs involve a direct transfer of funds from a taxable IRA to an operating 501(c)(3) organization of your choosing. Unlike typical IRA distributions, QCDs satisfy your RMD without increasing your taxable income. QCDs are capped at $100,000 per year per eligible individual and funds must be transferred directly from the custodian to the eligible charitable organization.
Start withdrawing funds before age 72
To reduce your RMD amount, you could start withdrawing funds from your tax-deferred retirement accounts before you turn 72. Starting at age 59½, you can withdraw money from your retirement accounts without an early withdrawal penalty.
Withdrawing money from your account will reduce the account balance — one of the key factors used in the calculation of your RMD. With a lower account balance, you’ll have a lower RMD once you reach age 72.
Plus, pulling money from your taxable account to help cover living expenses may also enable you to delay taking Social Security benefits. Up to age 70, you can earn delayed retirement credits that equal a guaranteed 8% annualized return for your Social Security benefit.
When implementing this strategy, be mindful of your tax bracket. You do not want to unintentionally withdraw too much from your taxable account that it pushes you into a higher tax bracket, as that would likely defeat the purpose of reducing your RMD.
In many cases, you can convert your eligible pre-tax accounts to Roth IRA accounts. This could be an effective strategy because RMDs do not apply to Roth IRAs. Unlike contributions to pre-tax accounts, you’ve already paid taxes on any contributions to your Roth IRA. Those taxes are calculated based on your tax bracket at the time your contributions were made, so money in your Roth IRA grows tax free.
If you retire before age 72 and your income drops in your first full year of retirement, there's a potential opportunity for a Roth conversion. You will be required to pay taxes on the total amount that is converted in the year that you convert it. However, the amount of taxes you pay will be based on your current tax bracket. Plus, after the conversion, your money will grow tax-free and won’t be subject to RMDs. Still, this can lead to a very hefty tax bill for the year the Roth conversion takes place.
Keep in mind, if you’re under 59½ years old, funds that are converted from a traditional IRA to a Roth IRA must remain in your Roth IRA for at least 5 years. Early withdrawals will be assessed a 10% penalty. If you’re 59½ or older, the amount you convert can be withdrawn with no early withdrawal penalty.
Reinvest your RMD
If your only option is to take the distribution as cash, you can reinvest the money in a taxable account, such as a brokerage account. You will have to pay taxes on the distribution, but reinvesting the money will allow your assets to continue to grow.
To make the process even easier, you can request an in-kind transfer from your IRA custodian. For example, you can request a transfer of shares from your IRA portfolio directly to your brokerage account to satisfy your RMD.
Another potential way to reinvest your RMD is by contributing to a 529 plan for a child, grandchild, or other friend or relative to use for education expenses. 529 plans offer several tax advantages. Earnings in a 529 investment account grow tax-deferred and withdrawals are tax-free for qualified education expenses (e.g., tuition, school supplies, books, meal plans, college housing). Most states also offer state income tax deductions or credits for 529 plan contributions.
Withhold taxes from your RMD
If you want to get ahead of your tax bill, you can choose to have taxes withheld from your RMD. This will not impact your total taxable income, but it will reduce the amount you owe when filing your annual tax return.
A Word on RMDs for Inherited IRAs
Explaining RMDs for traditional IRAs and employer-sponsored retirement accounts is relatively straightforward. RMDs for inherited IRAs, on the other hand, are more complicated.
An inherited IRA is an IRA account that is opened when someone (i.e., the beneficiary) inherits an IRA or employer-sponsored retirement plan after a person (i.e., the account owner) passes away.
RMDs are required for inherited IRAs, including Roth IRAs, but a complex set of regulations and a wide range of variables can make it tricky to calculate your exact RMD amount. How soon a beneficiary must start taking RMDs and how much the RMD is depends on a few variables specific to each unique situation, including the beneficiary's relationship to the account owner, as well as when (i.e., the calendar year) and at what age the account owner died.
In most cases, you’ll do one of three things as a beneficiary of an inherited IRA:
- Transfer the assets to your own retirement account and calculate RMDs as you normally would for that account (this option is only available to spousal beneficiaries)
- Transfer the assets to an inherited IRA and calculate RMDs to take each year
- Transfer the assets to an inherited IRA and distribute all assets within 10 years of the account owner’s death
Because of the complexities and differing regulations based on very specific scenarios, you may try using a specialized inherited IRA RMD calculator to determine your RMD for an inherited IRA, but we ultimately recommend talking with a financial planner or tax professional to avoid costly tax penalties.
Conclusion: Taking Required Minimum Distributions
After deferring taxes on your retirement savings, the federal government eventually wants to collect them. They do this by enforcing required minimum distributions (RMDs) on those retirement accounts.
Once you reach age 72, you’ll be subject to RMDs, which require you to take annual distributions from your IRA, 401(k), 403(b), SIMPLE IRA, or SEP IRA. RMDs must be satisfied by December 31 each year.
To calculate your RMD, you use a basic formula provided by the IRS:
Prior Year-End Fair Market Value of Account ÷ Your Life Expectancy Factor
When RMDs are taken, you’ll pay ordinary income taxes on those distributions. RMDs will count toward your taxable income and could potentially put you in a higher tax bracket. Depending on your specific situation, this can create ripple effects on taxes for Social Security income and Medicare.
It's important to fully understand RMDs and how to accurately calculate them, because if you fail to take your full RMD, you’ll receive a hefty penalty equal to 50% of the amount you didn’t take.
In years where you don’t actually need your RMD to supplement living expenses, you might consider making a qualified charitable distribution to reduce your taxable income, reinvesting your RMD into a taxable investment account or 529 plan, or withholding taxes from your RMD to help lower the amount you owe when you file your annual tax return.
RMDs are an essential (and mandatory) part of retirement planning. As financial planners, we help clients track and calculate their RMDs to avoid high penalties and provide optimal recommendations to minimize lifetime taxation.
If you need help developing a retirement plan, satisfying your RMDs, or managing your investments, our fee-only financial advisors are here for you. Book a free discovery call to learn more.