UPDATED: May 13, 2020
“RMDs” sound like they could be guided missiles. But they’re actually “Required Minimum Distributions” from retirement accounts. Still, RMDs can wreak havoc on retirement planning. Below, LNWM Client Adviser Brian Whitaker discusses why RMDs should be considered years before they start landing in your taxable accounts.
Q&A with Brian Whitaker, LNWM Client Advisor
Q: Brian, why plan ahead for Required Minimum Distributions?
Brian: We see lots of people who’ve had great success at their jobs and accumulated large pensions and other retirement accounts. The downside of all that success is that once you turn 72, a lot of those accounts require you to start taking annual distributions; in some cases, these annual payouts will be relatively large.
So RMDs can bump people into a higher tax bracket during retirement. Or the RMDs can make them subject to the additional Medicare premiums levied on high-income Medicare beneficiaries. These higher Medicare premiums, known as the “income-related monthly adjustment amounts,” can be reduced or avoided through careful planning. And this is just one of the reasons we like to start cash flow modeling for retirement some 10 to 15 years before our clients actually retire.
Q: What types of retirement accounts are subject to RMDs?
Brian: Most people know they’re going to be required to start taking money out of their IRAs and IRA-type plans [like SIMPLE IRAs, SEPs and SARSEPs].
But a lot of people don’t realize RMDs also apply to corporate pension plans like 401(K)s and most other employer-sponsored retirement accounts [like profit-sharing plans, 403(b) plans and 457(b) plans].
Q: What retirement accounts don’t have RMDs?
Brian: The RMD rules do not apply to Roth IRAs, while the owner is alive [because Roths are funded with after-tax money]. But there’s an important distinction here: RMDs do apply to Roth IRAs that are part of a 401(K) account.
In certain cases, it might make sense to convert regular IRAs and some other types of retirement accounts into Roth IRAs. You’ll owe income tax on all converted assets in the year of conversion, but assets will grow tax-free from then on and without future RMDs. Plus, a Roth also can be an effective way to pass tax-free assets on to heirs.
Another twist applies to retirement plans run by tax-exempt or non-profit organizations, including public schools and universities. These are known as 403(b) plans. If you made contributions to such plans before 1987, and those contributions are documented, the pre-1987 amounts are usually not subject to the RMD rule.
Q: When do RMDs start and how are they calculated?
Brian: The year you turn 72, you must take the first distribution. But you can delay that payment until April 1 of the following year. The minimum payout is your account balance on Dec. 31 of the previous year divided by a life-expectancy factor provided by the IRS. The life-expectancy factor differs depending on whether you’re married and how old your spouse is.
Q: What if you’re still working at age 72?
Brian: More people are these days. And there’s a bit of a difference then. If you’re still working at age 72, and do not own more than 5% of the business you work at, you can put off distributions from that employer’s retirement plan until April 1 following the year you retire. But you’d still have to take RMDs from IRAs and other employer plans.
Q: What happens if you don’t take the RMD?
Brian: Bad things happen. The shortfall is subject to a 50% penalty, and you have to file an extra tax form for that. If it was an honest mistake, you can file the form (Form 5239) and request a waiver of the penalty.
Q: What else is important about RMDs?
Brian: The key takeaway about RMDs is to plan ahead for them. Once they start, there’s not a whole lot you can do to minimize them, other than the Roth IRA conversion I mentioned earlier.
Also, you should always consider:
- From which retirement account(s) do you take the total required distribution? You have to calculate the RMD for each retirement account separately, but you can withdraw the total RMD due from just one or more of your accounts;
- Does it make sense to take out more than the required minimum? In some cases, it might be beneficial to withdraw more than the RMD in any one year. But you can’t use that to offset RMDs for future years.