Required minimum distributions, often referred to as RMDs or minimum required distributions, are amounts that the federal government requires you to withdraw annually from traditional IRAs and employer-sponsored retirement plans after you reach age 70½ (or, in some cases, after you retire). You can always withdraw more than the minimum amount from your IRA or plan in any year, but if you withdraw less than the required minimum, you will be subject to a hefty federal penalty. The penalty is 50% of the under-withdrawn amount.
The RMD rules are calculated to spread out the distribution of your entire interest in an IRA or plan account over your lifetime. The purpose of the RMD rules is to ensure that people don’t just accumulate retirement accounts, defer taxation, and leave these retirement funds as an inheritance. Instead, required minimum distributions generally have the effect of producing taxable income during your lifetime.
Because RMDs are calculated as a percentage of your total account value, more money in your retirement account means larger RMDs. This can cause a tax planning problem for many retirees who are relying on their 401k’s and rolled-over pensions to support their retirement.
- Many retirees have less tax deductions and don’t actually end up in a lower tax brackets during retirement. Remember, these retirement plan assets create ordinary income.
- Many retirees pay more taxes on their Social Security benefits because of additional “provisional” taxable income created from retirement plans.
- If tax rates go up during retirement your retirement income stream will take a hit. Which direction do you expect tax rates to go?
These are a few reasons that understanding and estimating your future RMDs is a crucial part of retirement planning.
You should also know how to handle your IRA when one spouse passes away. A spouse who is under 70 1/2 will have to take RMDs if they title the IRA as an inherited IRA, but if they roll it into their own name they won’t have to take RMDs until they are 70 1/2. A non-spouse beneficiary doesn’t have this option.
There are many rules and many different ways to calculate RMDs depending on your situation. Always make sure to work with a financial professional that understands the full scope RMDs in financial and tax planning.