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After many years of building up your retirement accounts, there comes a time where you need to change your mindset and withdraw from them instead. It can be confusing to decode all of the IRS rules surrounding required minimum distributions (RMDs). Essentially, you need to know the answers to the following questions:
- What is an RMD?
- Why Am I Taking an RMD?
- When Do I Need to Take My RMD?
- How Do I Take My RMD?
In this guide, we answer all of your burning questions about RMDs. It’s important to understand how taking a distribution affects your situation so that you can come up with an efficient tax and spending strategy.
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What is a Required Minimum Distribution (RMD)?
A required minimum distribution, or RMD, is the minimum amount that the IRS requires you to withdraw from your retirement account each year, beginning at the age of 70 1/2.
An RMD will be applicable on the following account types, and each is calculated separately. Therefore, requiring a separate obligation for each account type.
- Employer-sponsored retirement plans (401k, 403b, 457b, etc)
- Roth 401(k)
- Traditional IRA
- Rollover IRA
- SIMPLE IRA
- SEP IRA
After years of tax-deferred savings, the IRS mandates this so they can collect taxes from you. RMDs are not required on Roth IRAs.
If your RMD is from a traditional IRA, you can delay taking your first distribution until April 1st of the year after you turn 70 1/2 . Every year afterward, you will need to take your RMD by December 31st.
An RMD will count toward your total taxable income for the tax year, and is taxed at your ordinary federal income tax rate. It also may be subject to state and local taxes. Many institutions allow you to have taxes withheld through them. However, if you’d prefer, you can elect to not have taxes withheld and instead handle it with your accountant at tax time.
We suggest planning to take it ahead of time and not waiting until the last possible day. Failing to do so can result in a 50% penalty on the RMD amount not taken on time, in addition to tax payments.
If this happens, you’ll need to file Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts, with your federal tax return. You can attempt to request that the penalty be waived on the same form. However, you must attach a letter of explanation that explains the shortfall.
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How Do I Calculate My RMD?
Many IRA custodians or retirement plan administrators will automatically calculate your RMD for you at the beginning of the year as a courtesy. This is helpful because if you need to sell some of your investments into a cash position beforehand, you’ll be able to do so with plenty of time to spare. However, it is ultimately your responsibility to calculate it.
Your RMD is calculated by taking the balance of your account as of December 31st of the prior year and dividing it by your life expectancy factor. Your life expectancy factor is determined by the IRS and published in Tables in Publication 590-B.
If you’d like to calculate your RMD yourself, try using the IRS required minimum distribution worksheets.
How Do I Set Up My RMD?
The first step to setting up your RMD is to contact the financial institution holding your retirement account. They can help you set up a one-time or recurring distribution. Consider going the automatic route to avoid any potential consequences as a result of forgetting to take your RMD.
Some elect to have the money withdrawn once a year while others like to split it up into monthly payments. Dependent upon your preference, they can send the money to your bank via direct deposit or to your home address via check. You can choose to take exactly the amount of your RMD, or to take more.
Another option is to set up a nonretirement account and have the money transferred from your IRA. It’ll still count towards your RMD because you’re taking the money out of your retirement account, which is a taxable event. This option is beneficial to those who want to keep the money invested rather than using it for other expenses.
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What Can I Use the RMD Funds For?
There are many different ways that you can use your required minimum distribution. Some people may use their RMD towards their budget in retirement to cover living expenses. Others may want to keep it invested or use it for a luxury vacation or purchase. Overall, consider your financial plan and goals to determine the most beneficial use of the money.
1. Regular expenses
If your retirement accounts are an essential part of your retirement plan, use your RMD towards your monthly budget. This method counts as using the money towards expenses like your mortgage or rent, utilities, auto loans or maintenance, insurance, and food or entertainment.
2. Pay Off Any Remaining Debt
If you have any debt, it’s a good idea to use any remaining RMD funds as a principal payment towards these obligations. Your income is your most valuable tool. Paying off your debt will remove the financial burden and stress, as well as save you money on interest.
3. Increase Your Emergency Fund
Increasing your emergency fund is another smart use of your RMD. Everyone comes across unexpected expenses during their lifetime, and having a solid emergency fund will eliminate the necessity to take out debt. An emergency fund could be used for events like a health emergency, or an unexpected car or home repair.
4. Enjoy a Trip or Luxury Purchase
If you’ve been sticking to your financial plan, an RMD may seem like a bonus to you. If you have the rest of your obligations covered, consider responsibly splurging. Enjoy a vacation that you’ve always wanted to take or make a luxury purchase for something you’ve always wanted. Just make sure to only do so if you have enough cash to pay for it in full.
5. Reinvest the Money
You may have all of your retirement spending covered between Social Security, a pension, or other retirement accounts. Even if an RMD seems unnecessary to you, the IRS still requires you to take the money out each year.
While you can’t reinvest the RMD back into a tax-advantaged account, you can look into transferring it to a taxable brokerage account. This will allow you to satisfy your obligation while still keeping the money invested.
Investing options within a taxable brokerage account could be very similar to what you invested in within your retirement account. Contact your financial institution to see what is available. However, some examples of investments you can consider are: stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Remember to consider what your investment goals are when making a decision. Typically, stocks are more risky while bonds are more conservative.
6. Estate Plan
If you’d prefer to use your RMD to start future savings for your loved ones, that’s an option too. You can choose to start a 529 college savings account or a minor Roth IRA for your grandchildren. This will set them up for a great start well into the future.
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Alternatively, you could even convert some of your traditional IRA savings into a Roth IRA for your heirs. You’ll be responsible for paying the taxes on the conversion, and whomever inherits the money will do so tax-free, minus any applicable estate taxes (as long as the Roth IRA is at least 5 years old and the distributions are qualified).
When deciding if this will be a good option, you’ll need to anticipate which tax bracket your heirs will be in. If you expect them to be in a lower bracket than you are currently, it won’t make sense to complete the conversion.
Another option would be to use your RMD to begin a trust or gift money to others. There are many ways to transfer your money to heirs, and you should always consult an estate planner before deciding what is best for you.
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Is There Any Way I Can Reduce Taxes On My RMD?
For high-income earners who want to optimize their tax strategy, they can consider donating their RMD instead. A Qualified Charitable Distribution (QCD) is a direct transfer of funds from your IRA to a qualified charity up to an annual maximum of $100,000. Your RMD would therefore be satisfied, but it would not be counted towards your gross income because you donated it.
A QCD in excess of $100,000 is included as income, and you must be at least age 70 ½ when the distribution is made. Keep in mind that you cannot claim a donation deducation on your taxes if you complete a QCD.
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How Does An RMD Apply to Me As An Immigrant?
Your eligibility to contribute to a 401(k) or IRA throughout your time in the United States largely depended on your citizenship and tax status. Both citizens and non-citizens can have retirement accounts if they’re eligible to work and live in the country. Since you paid income taxes and were eligible for retirement plans, you’ll also be required to take an RMD once you reach the age requirement.
Have a Plan: Distribute Your RMD by December 31st Each Year
If you have built up a tax-deferred retirement account over the years, it is likely to become a significant part of your retirement plan. Even if you don’t have a targeted use for these retirement funds, the IRS still requires you to take your RMD each year. You’ll need to consider your financial goals to make sure that the money is efficiently used. After you cover all of your necessary financial obligations, consider reinvesting your RMD funds into a nonretirement account.
Make sure that you plan ahead and contact your financial institution to distribute the funds ahead of time in order to avoid the penalty. This prevents undue stress for either party by ensuring you fulfill your obligation on time and that your tax forms are filled out correctly. When you understand required minimum distributions and the effect it has on your tax obligations, it makes it much easier to handle your finances.