What Are Required Minimum Distributions (RMDs)? A Primer for Your 70½ Birthday

Are you about to celebrate your 70½ birthday? If so, congratulations—it's time for the gift-giving. In this instance, though, you're the giver, and the recipient is none other than your old Uncle Sam. What are you giving? More tax payments, of course, generated from taking required minimum distributions (RMDs). But, what are these RMDs and why do you have to pay taxes on them?

Required minimum distributions are the way the IRS prevents people from hoarding money indefinitely in retirement plans. If you have any tax-deferred retirement accounts, such as a traditional IRA, 401(k), 403(b), profit-sharing or other defined-contribution plan (except for Roth IRAs—more on that in a bit), you're almost certainly subject to RMDs. These are amounts the government requires you to take withdrawals from your tax-deferred accounts each year, at which point they’re declared as income. And that means it's time to pay taxes on them.

Failure to meet your RMD requirement can be costly. The penalty assessed for not taking out enough is 50% of the difference between your RMD and what you actually withdrew from your tax-deferred accounts.¹ For example, if your RMD was $10,000 and you only took $6,000, you would be assessed an additional penalty of half the $4,000 difference, or $2,000.

Why Does Uncle Sam Care?

A tax-deferred plan means exactly that—when you make deposits into your retirement account, that money isn’t counted towards your taxable income (because it either gets taken out of your check before taxes were paid or can be deducted, within the IRS limits, on your tax return when you file). Not only does this allow you to defer taxes on that income, but you are also allowed to trade and hold securities to grow the account without paying the associated income- or investment-related taxes along the way.

Uncle Sam can be patient, but he won't wait forever. You can generally begin taking distributions from these types of retirement accounts at either 55 or 59½, depending on their type (50 for some accounts if you qualify as a Public Safety Officer), at which time you have to start paying taxes on them. But, taking distributions at the specified age isn't mandatory. If you continue working or simply have no need of the money in the account, there is probably no reason to start taking them as doing so is only likely to reduce the potential compounding growth of your savings. In fact, if you continue working during these years, you might still be contributing to a plan. If you’re retired once you reach age 70½ though, you can defer no longer and must begin taking out a certain percentage each year.

Money in a Roth IRA, however, isn’t impacted by required minimum distributions because all contributions are, by requirement, made with money you’ve already paid taxes on. In other words, if you have money in a Roth IRA, you paid on the way in, so you don’t have to pay on the way out. The benefit of a Roth IRA is that the funds are tax exempt, meaning you won’t have to pay capital-gains taxes when you sell securities. Your distributions are taken tax free, so the IRS doesn’t require you to take out an annual minimum.

But here's a curious thing: If you have a Roth 401(k) or Roth 403(b) plan, even though you don't owe taxes on distributions, you're still subject to required minimum distributions. However, it’s relatively rare for this situation to arise, as most retirees will have rolled these plans into Roth IRAs upon leaving their employers. Remember though, employer contributions to Roth 401(k) or Roth 403(b) accounts will have gone into a traditional version of these, which are going to factor into RMDs.

Calculating Your Required Minimum Distributions

The IRS website has tables and worksheets² to help you calculate your RMDs. You’ll need to know this value for every eligible account you own, though in some cases the account custodian (normally your broker, retirement-plan sponsor or bank) may calculate an RMD for you based on your account’s value at the end of the previous calendar year. Still, this isn’t always the case so you may want to consult a CPA or tax advisor to calculate this for you. Whatever your particular case, it pays to know the basics of these calculations to help you plan accordingly:

How old are you, and in which calendar year did you reach that age? For your first required minimum distribution, you have until April 1 of the following calendar year to take that first withdrawal. For every year after that, the distribution must be taken by December 31 of that year. A word of caution on that first withdrawal: Since each distribution is a taxable event in the calendar year in which it is taken, if you wait on the first one, you'll have to report two years' worth of RMDs in your second year.
What is your life expectancy (according to the IRS)? Depending on your marital status, the difference in age between you and your spouse, and how you've structured your beneficiary’s benefits, you'll choose from one of three tables on the IRS website to determine your life expectancy, or what the IRS calls a "distribution period," quoted in number of years.³

Dividing your account balance by the distribution period will give you a good estimate of your RMD. For example, suppose you've just reached 70½, but you'll turn 71 by the end of the year. Let's further assume that your end-of-year 401(k) account balance is $600,000, you're currently married, your spouse is two years younger than you, and your spouse is not your sole beneficiary. Under this scenario, you would choose Table III, the Uniform Lifetime table. Consulting the table, we see that the distribution period for a 71-year-old is 26.5.⁴

Dividing $600,000 by 26.5 equals $22,641.51. That's your hypothetical required minimum distribution for the current year. Each year you'll have a different RMD based on the account balance and your distribution period from the table. Be sure to check with your tax professional to confirm your RMD calculations and to answer any questions you may have.

Do you own more than one tax-deferred account? You may have two different RMDs, one based on all of your IRA plans and one for all of your Defined Contribution Plans (401(k)s, 403(b)s, 457s, etc.). Each of these RMDs is calculated based on the collective value of all accounts of that type. While you must use money from IRAs for your IRA RMD and Defined Contribution Plan money for your Defined Contribution plan RMD, there's no required minimum from a particular account. To clarify, you can’t count money withdrawn from a 401(k) towards the RMD calculated for your IRAs or vice versa; but, if you have both a 403(b) and a 401(k), you could take your entire RMD from just one regardless of the individual RMD amounts required for each account.

Death and Taxes

You may also be surprised to learn that your required minimum distributions can outlive you. If you either pass on a tax-deferred retirement account or are the beneficiary of one, the original RMDs may still apply. In general, the beneficiaries of tax-deferred accounts have three options.

Treat it as your own IRA. This means you won’t be paying RMDs until you reach 70½, but you’ll also be subject to all the other rules and restrictions that apply to your IRA accounts, such as the penalties for any early withdrawals.
Continue taking RMDs. Spousal beneficiaries under Table III may continue taking distributions at the same rate as the original owner. Non-spouse beneficiaries, and spouses who are more than 10 years younger than the original owner, may elect to stretch distributions over a longer period. Tables I and II on the IRS site show life expectancies for such beneficiaries.⁵
Defer distributions for up to 5 years. If you elect this option, there is no required minimum distribution for any single year. But, you must withdraw the entire account balance (paying the associated taxes) by the end of the fifth year.

What to Do with Your Required Minimum Distributions

If you're planning to use your RMDs to fund your basic living expenses, the choice is rather simple. You or your account custodian sells off assets (or withdraws dividend/interest payments) in an amount sufficient to cover the required minimum distribution(s), calculates the amount to be paid in taxes, and disburses the remainder to you. This can be done on a periodic basis, or it can be done once annually. However, if you do not need the proceeds for living expenses, you have several options.

Charitable donations. While RMDs increase your taxable income, charitable donations can be deducted from it. This means that supporting your favorite causes may enable you to offset some or all of the extra tax burden of your RMDs. Be sure to check with your tax professional about limitations on charitable contributions and other factors that may affect your ability to do this.
Reinvest. Just because you need to pay taxes doesn't mean you have to liquidate your holdings. You can move stocks, bonds, funds and other holdings directly into traditional taxable investment accounts, so you may not need to incur liquidation costs. The value of these securities when they are transferred counts towards the required minimum distribution. This is still considered taking income even though it’s not in cash, so you'll still owe income taxes based on the securities’ value. An important note: future taxable gains and losses on these securities are calculated relative to the their value when they are transferred, not their original purchase price.
Indulge. If you've been eyeing a trip, a luxury vehicle or other indulgence, your RMDs may be the excuse you're looking for to go through with the purchase. Note, you may end up paying additional sales, excise, luxury or other taxes, depending on where you’re hoping to spend this money; so consider the opportunity cost of this spending relative to reinvestment that continues to let your savings grow.

Let Fisher Investments Help

If you’re still asking yourself, “What are required minimum distributions really going to mean for my retirement plans?” then Fisher Investments may be able to help you determine how required minimum distributions may impact your retirement income and savings. As a professional investment adviser, our firm can help you balance accounts to minimize the impact required minimum distributions have on your ability to fund your retirement. With a simple, fee-only structure and support teams dedicated to keeping clients informed, we take pride in helping our clients reach their retirement goals.

Request an appointment with one of our specialists today, or you can browse our selection of retirement planning guides for more information and advice.

¹Source: Internal Revenue Service, as of 03/12/2018. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
²Source: Internal Revenue Service, as of 03/12/2018. https://www.irs.gov/publications/p590b/index.html#en_US_2015_publink1000231258
³Source: Internal Revenue Service, as of 03/12/2018. https://www.irs.gov/publications/p590b#en_US_2016_publink1000230772.
⁴Source: Internal Revenue Service, as of 03/12/2018.https://www.irs.gov/publications/p590b#en_US_2016_publink1000231217.
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