Required Minimum Distributions: What You Should Know
What are they?
If you own a traditional IRA, or you have a 401(k) or similar account through a former employer, you generally have to start taking money out of these accounts once you get into your seventies, like it or not. The minimum you have to withdraw is called a "required minimum distribution."
Of course, most people need the money anyway - so RMDs are not an issue. But if you don't need more cash to spend, there are good reasons to leave the money where it is, as much as possible:
- The plans in question all allow your accounts to grow without immediate taxation, which makes a big difference over time.
- When you do withdraw money from such retirement accounts (except Roth accounts), you have to pay taxes.
- Sometimes the taxable income you get by taking RMDs can increase the taxes on Social Security benefits.
- Timing may also be an issue. Some years are better than others for liquidating investments, but RMDs require withdrawals each year, regardless.
What kinds of plans are affected?
Required minimum distributions apply to:
- Traditional IRAs (Individual Retirement Accounts other than Roth IRAs).
- Most "qualified" employer-sponsored retirement plans (401(k) plans, 403(b) plans, Simplified Employee Pension plans, Simple Plans, and most other plans with an account balance owned by you).
- Roth 401(k) and Roth 403(b) plans.
RMD's do not apply to:
- Roth IRAs
- Most "non-qualified" employer-sponsored plans (Section 457 plans, or plans offered by for-profit companies as a benefit to high-level employees).
- Individual annuities owned by you outside one of the previously mentioned kinds of retirement plans.
- Life insurance policies
- Bank accounts, mutual funds, or other savings or investments that you own outside of formal, tax-sheltered retirement plans.
How RMDs work: the Basics
When RMDs start. In most cases, the so-called "Required Beginning Date" is the year after you turn 70½. If you are older than that but are still working for the employer sponsoring the plan in question, and assuming you do not own 5% or more of that employer, you can further postpone RMDs until you retire. But the Required Beginning Date for traditional IRAs is always the year after you turn 70½, regardless of whether you are still working.
How much you have to withdraw. There are two ways to handle this:
- The simplest is to convert the fund to an annuity that will pay out a lifetime benefit to you, though such a decision should not be based on this factor alone.
- The normal way is to withdraw at least a certain percentage of the fund every year, as specified by the IRS. As a rule, while you are still in your 70s, only 4-5% of your fund needs to be withdrawn every year, in your 80s it's more like 5-8%, and in your 90s it's about 9-15%. Lower percentages can be used if you are married and your spouse is more than 10 years younger. Financial companies holding the funds must notify you every year how big a withdrawal is due, so you may not need to track this requirement yourself.
What happens when you die. This depends on who, if anyone, is named as the beneficiary of your account. If your spouse is the beneficiary, then the account will be treated as the beneficiary's own, and RMDs will be required (or not) based on his or her age. If else is beneficiary, RMDs will have to start right away, based on the beneficiary's age. If no personal beneficiary is named, RMDs will be based on your age at death (if you already started taking RMDs), or the entire fund will need to be paid out within 5 years (if you haven't started yet).
If you have more than one plan or account. Calculations must be done for each plan. The RMD calculated for each plan or account must be taken from that plan or account, except: (1) if you have multiple IRAs, the IRA withdrawals can come from any one or more of those accounts; (2) if you have multiple 403(b) accounts, the 403(b) withdrawals can come from any one or more of the 403(b) accounts.
Tips and suggestions
- As usual, there are variations and exceptions, and the plan sponsor or financial institution may not know if these apply to you. So if you want to minimize your RMDs, have your personal financial advisor review them.
- Since Roth IRAs are not subject to RMDs, you may wish to convert or roll over other plans to a Roth IRA if you want to avoid RMDs. For conversions from plans other than Roth 401(k) and Roth 403(b), however, this process will generate immediate and possibly substantial taxes. That could kick you into a higher tax bracket, and/or affect taxation of Social Security benefits.
- To minimize required distributions after death, a beneficiary should be named for each plan or account, particularly if your spouse is to inherit it (even if your spouse is named in your will to inherit your account).
- You can take RMDs any time during the year. Usually, it's best to wait until the end of the year, since that allows more time to earn tax-deferred interest. But keeping an eye on market conditions may enable you in some years to time your withdrawal more favorably.
- If you are still working at age 70½, and own an IRA, you have to take RMDs from the IRA, but not from your 401(k) or other plan at work. If you want to avoid RMDs on the IRA and intend to keep working for a while longer, you could roll over your IRA into your 401(k) or other employer-sponsored plan. But consider this carefully, as there are other pros and cons.
- If you have one IRA with illiquid assets or one that is performing exceptionally well, and you have another IRA that is more ordinary, remember that all of your IRA RMDs can come out of the second IRA and you can leave the first one intact. If you don't have a second IRA, you need to keep RMDs in mind as you get older, and make sure that your account has enough liquid funds to pay out the necessary amounts.
- You can also take IRA withdrawals "in kind." If your IRA owns individual stocks, for example, you can have the stock certificates taken out of the IRA and re-issued to you individually. This saves you commissions on selling and then re-buying the investment, assuming you do want to keep it.
- Although you can postpone the first RMD (and only the first) to April 1 of the following year, this is usually not advisable. Because of the calculation method, if your account is growing you will end up having to withdraw more by waiting, and a few extra months' earnings will rarely make up for it. Also you double up on the income taxes you need to pay the second year, because you end up having to make two RMDs.