If you’re one of the millions of Americans who have enjoyed the benefits of tax-deferred investing in traditional IRAs, 401(k), or similar retirement savings accounts, you should be aware of the rules governing the required distribution of those assets.
At age 72, most holders of traditional IRA, 401(k), 403(b), 457(b), SEP, SIMPLE, and profit-sharing plans must begin withdrawing required minimum distributions (RMDs) from their accounts – and paying taxes on the distributions at their ordinary income tax rate. The IRS requires them to take withdrawals from these accounts by April 1 following the year they reach age 72, and annually by December 31 thereafter. If you postpone the first year’s distribution, that means that in the year after you turn 72, you may have two required distribution dates – April 1 for the previous year and December 31 for the current year.
Even if you’re not at the age to withdraw RMDs, it’s worth being prepared by knowing the exceptions, tax implications, and strategies for maximizing those distributions. (See: CARES Act seeks to assist individuals and businesses during COVID-19 crisis)
Roth IRAs. There is no RMD for Roth IRAs regardless of your age. Furthermore, if you are 72 and you’ve had the account for at least five years, all of the distributions that you do take would normally be tax-free. By contrast, Roth 401(k) account holders are generally required to begin taking distributions at 72, although they typically would not owe income taxes on qualified withdrawals. (See: Benefits of Roth IRAs Go Well Beyond Retirement)
Still working. There is no age limit on contributing to either a traditional IRA or Roth IRA as long as you have earned income. If you’re still working into your 70s, you can continue to contribute to your 401(k) or other employer-sponsored plan. What’s more, you generally don’t have to start taking distributions from that 401(k) for as long as you continue to work. Your first RMD would be due by April 1 of the year after you retire. However, if you delay your first distribution until April 1, you will also have to satisfy the current year distribution by December 31 of the same year.
However, this exception would not apply if you have a stake of 5% or more in the company. You cannot delay your RMD and must begin distributions. Nor would it apply to any retirement plans of former employers or to IRAs. Even if you’re still working, you would be required to begin taking distributions from your IRAs and former employer retirement plans at age 72.
What to do with your distributions
With potentially thousands of dollars coming your way in the years ahead, you may need a strategy to get the most from your distributions.
Before you decide on any course of action in allocating your distributions, you should consult with a tax professional to make sure you’re making the best decisions based on your specific tax situation. If you expect to spend the money to cover retirement expenses, that’s probably an easy choice. Take the distribution, pay the taxes you owe, and use the money as needed. But if you are already receiving enough income to cover your bills through a job, Social Security, or any pension or investment income, it may help to develop a strategy for making the most of your distributions. Here are some options for doing just that:
Donate it. If you donate your distribution – or a portion of it – to a qualified charity, the amount of the distribution you donate is taxable, but may qualify as a tax deduction. (See: "Donor Advised Funds" Mix Charity, Investing and Flexibility)
Make a qualified charitable distribution (QCD). When you reach 70½, you can request up to $100,000 be sent directly to a qualified charity as a non-taxable distribution from your IRA. The QCD also counts towards your RMD for the year once you reach age 72. But if you make deductible traditional IRA contributions and also request a QCD, the QCD amount will be reduced by the amount of the traditional IRA deductions.
Create an emergency fund. If you don’t already have an emergency fund, you may wish to use some of the after-tax distribution to set one up.
Fund your life insurance premiums. You may use RMDs to fund a life insurance policy. The policy could be used to defray the tax on your retirement assets that your family will receive. Or, you could name a charity as the beneficiary of your taxable retirement accounts, with your family being the beneficiary of your non-taxable life insurance.
Reinvest it. You may choose to invest your after-tax distribution in a mutual fund or other investment in an effort to keep it growing. There are a wide range of mutual funds available – the choice depends on your investment objectives. (See: Asset Allocation Funds Can Help Tame Volatility)
Start early and move some money to a Roth IRA. Even if you’re years away from turning 70, it may be helpful to plan ahead.
While you are not allowed to roll over your RMDs into a Roth IRA, you may be permitted to convert the remaining money within your retirement accounts to a Roth IRA. Keep in mind, however, that you would be required to pay taxes at your ordinary income rate on the money you convert in the year of the conversion.
After 5 years, and you’re 59½, disabled, first time home buyer ($10,000 limit) or the money is being paid to your beneficiary, all earnings can be withdrawn tax-free.
Having a source of tax-free income could give you more flexibility in controlling your tax liability in future years. (Note that access to converted dollars before age 59½ has restrictions.) (See: The Power of Pairing a Roth IRA with Your 401(k))
You can start the conversion process well before age 70 – and you can continue the conversions until you’ve emptied your tax-deferred account – as long as you don’t convert your RMDs. (See: Benefits of Roth IRAs Go Well Beyond Retirement)
Once your money is in a Roth IRA, you would no longer be required to take distributions during your lifetime. One of the key considerations is whether you can pay the taxes you will owe on the conversion from a separate source, rather than using your IRA assets to pay them. If you use IRA assets and you are under age 59½, you will owe the 10% early distribution tax on any funds not included in the amount converted to the Roth IRA.
Before making the decision to convert some or all of your tax-deferred account to a Roth IRA, you should carefully consider the tax consequences or speak with a tax professional to discuss the pros and cons. For instance, to help reduce the tax impact, you might consider spreading your conversions over several years – or waiting until you’re in a lower tax bracket in order to limit the tax burden.
But whether you withdraw the money now, or later when you’re required to take the annual distributions, you’re going to owe taxes at your ordinary income rate on all the money you withdraw. The decision you face is whether to take the hit sooner or later.
How much of my money must I withdraw each year?
During your lifetime, required minimum distributions (RMD) are determined through a calculation based on your age and the relationship and age of your beneficiary(ies) and the amount of money in your account as of December 31 of the prior year.
You would divide the amount in your account by the distribution period to determine your required minimum distribution.
Fortunately, you may be able to get some help from your plan administrator or tax professional. The trustee, custodian, or issuer of your account must either report the amount of the distribution to you or offer to calculate it for you. Or you could use an online calculator to do the math. FINRA has an RMD calculator at its site. You can also consider setting up a systematic distribution that is taken timely each year.
Review for more information on RMDs and Life Expectancy Tables
When must I take my distributions?
You must take your first distribution for the year you turn age 72, although the first payment can be delayed until April 1 of the following year. After the first year, all annual distributions must be taken by December 31 of that year. If you postpone the first year’s distribution, that means that in the year after you turn 72, you may have two required distribution dates – April 1 for the previous year and December 31 for the current year.
Can I make things easier by doubling my distribution one year so I can skip it the next?
Not a chance. You must recalculate the amount and take your distribution every single year.
What if I don’t take the full required distribution?
You would be subject to a stiff penalty – a 50% excise tax on the amount of the required minimum distribution that you failed to take in a particular year. You may withdraw more than your RMD at any time, but you must not withdraw less.
What if you have more than one applicable account?
If you have more than one IRA or other employer retirement accounts, you must calculate the required distribution separately for each account. You must then withdraw an amount equal to the total of the RMD for all of your accounts.
You can withdraw the RMD for your IRAs from any of your IRAs (except for an IRA annuity that you’ve annuitized) but, in most cases, you must take the RMDs for any other retirement accounts directly from that account. For instance, if you have a 401(k), you must take the RMD from that account, and if you have more than one 401(k), you must satisfy the RMDs for each of those separately.
If you have a 403(b), you must also take your RMD from that separately. The exception is if you have a traditional 403(b) account and a 403(b) annuity, you can aggregate both of these for RMD purposes.
Where can I learn more about RMDs?
For further details, you can go to the IRS.GOV RMD section.