Throughout our careers, we work to set aside money for retirement. Financial and retirement planners encourage their clients to have diverse retirement portfolios, choosing the right investment products and strategies to maximize savings in an effort to weather volatile market conditions. Creating a diverse retirement savings portfolio can include such products as stock and bond investments, employer-sponsored 401(k) and 403(b) plans, Traditional or Roth IRAs, and even real estate purchases. With this diversity, an individual is able to ensure a stable and secure financial future.
Unfortunately, the concept of Required Minimum Distributions (RMDs) can create issues when it comes to planning for retirement. In this guide, we will explore RMDs and what they mean for the retirement savings strategy, then present solutions that help RMDs work for you and for your financial goals.
What are Required Minimum Distributions (RMDs)?
Certain qualifying retirement accounts mandate a minimum amount that must be withdrawn after the account holder reaches the year in which he or she turns 70 ½ years of age. These are called Required Minimum Distributions, or RMDs. Regulations require RMDs be withdrawn from the following retirement accounts:
- Traditional IRAs
- SIMPLE IRAs
- SEP (Simplified Employee Pension) IRAs
- 401(k) Employer-Sponsored Retirement Plans
It is important to note that Roth IRAs do not have an RMD requirement; account holders may keep funds in the accounts and withdraw them when they desire, provided they have reached the age of 59 ½ and the account is at least 5 years old.
Regulatory Penalties Regarding RMDs
There are a number of complexities when it comes to RMDs, particularly when an individual is the account holder for multiple retirement accounts. Mismanaging required distributions, or failing to take the distributions within the regulatory timeline, can result in significant penalties. Here are some of the potential pitfalls when considering RMDs:
- An RMD must be taken by April 1 of the year following the year the account holder reaches 70 ½ years of age. The RMD may be taken earlier, but cannot be done past the April 1 deadline. In each subsequent year, an RMD withdrawal must be taken as well. Failure to make timely withdrawals can result in a penalty of 50% of the RMD amount.
- Leaving employer-sponsored 401(k) plans in place instead of rolling over assets into an IRA, leading to an oversight and the same 50% penalty as missing the deadline for withdrawal.
- For multiple account holders, such as an individual with multiple plans from the same employer or those with different retirement accounts from different employers, RMDs are calculated separately and distributed separately from each account. If the calculated amount for any of the accounts is incorrect or not taken by the deadline, a penalty tax equaling 50% of the amount not withdrawn is taken.
- Some employers offer a Roth 401(k) plan. Unlike a standalone Roth IRA, RMDs must be withdrawn from these accounts in accordance with age regulations. This has often created confusion among account holders, who may believe that because it is Roth-based, it is immune from the distribution requirements. The good news here is that distributions from Roth 401(k) plans are tax-free.
Solutions for RMDs: Making Them Work for You
There are several strategies retirement account holders can use to actually make RMDs work in favor of financial goals. Avoiding tax penalties is central to each of these strategies, and the RMD can provide much-needed retirement income in a steady, reliable manner. Let’s take a deeper look into some of the RMD strategies you can use to make them work for your specific needs.
It is possible to use withholding to avoid a penalty on tax underpayment. The taxes withheld from an RMD are treated as being paid to the Internal Revenue Service (IRS) at an even rate throughout the fiscal year, even if those taxes were paid on December 31 of the previous year. In effect, account holders can use this to retroactively make up an earlier tax underpayment. Here’s an example to make this process clearer:
Imagine that you had some type of investment income during 2018, such as proceeds from a real estate sale or rental income, and you failed to pay the estimated tax on that income. When it is time to file your tax return, you will owe the estimated tax and chances are a late-payment penalty as well. Instead, pay the tax by withholding it from an end-of-year RMD (by December 31), and it will be treated as paid in a timely manner, thereby eliminating the steep tax penalty.
Lowering the Tax Bill
To take your first RMD, it is possible to receive it in the year that produces the lowest tax bill. In general, RMDs must be taken by December 31 of whichever tax year you are considering. The first RMD, however, can be taken no later than April 1 of the year following that which you reach the age of 70 ½. As an example, if you are required to take your first RMD in 2018, you can lower your tax bill by choosing to take your first RMD in 2018 or 2019, or whichever of the two years produces the lowest tax bill.
Qualified Charitable Distributions
A Qualified Charitable Distribution, or QCD, can cover your RMD. A QCD is a direct transfer from your qualifying retirement account (IRA, SEP, 401(k)) to a charity for amounts as much as $100,000. This amount is not included in your annual income, providing the same tax benefit as any other charitable contribution. In some ways, it is even better than a traditional charitable contribution, as the individual does not need to file an itemized return to use this mechanism. A QCD does not increase adjusted gross income, unlike an RMD. So, in order to maximize the benefits, make the QCD to the charity of your choice, then take the RMD as required by federal regulations.
Under current regulations, once a person reaches the year in which he or she turns 70 ½, RMDs must be taken. However, it is possible to start taking distributions from an IRA or other qualifying retirement accounts before it is required. This is especially beneficial in a low tax bracket year; a low-tax distribution taken now will reduce future higher- tax RMDs in the future. It is possible to increase Social Security (SS) benefits as well by taking strategic distributions from qualifying retirement plans; any SS benefits delayed past the normal retirement age allow for an increase in benefits of 8% per year. Taking an IRA distribution to replace SS for several years before turning 70 can help you increase your SS benefit to a 32% larger sum for the remainder of your life.
RMDs don’t have to be confusing or subject to steep penalties. With the guidance of a tax professional and a certified retirement planner, you can make these required distributions lower your taxes, increase your Social Security benefits, and provide income for a stable, secure, and comfortable retirement.