If you’ve reached retirement age and have money sitting in an IRA or a workplace retirement plan, you’ve probably heard the term ‘required minimum distribution (RMD).’
It’s an important concept to understand because failure to comply with the rules surrounding RMDs can cost investors hundreds, if not thousands, of dollars in taxes and penalties.
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What is a Required Minimum Distribution?
The IRS requires that investors with retirement accounts begin taking withdrawals from them when they turn age 70½. The amount that must be withdrawn is based on the balance within these accounts and the owner’s remaining life expectancy, which is based on a table furnished by the IRS. Since these factors change every year, the required minimum distribution amount must be recalculated annually. The taxable portion of any amount withdrawn from an IRA or other retirement plan gets taxed as ordinary income. Since accurately calculating the required minimum distribution can be complex, many financial institutions will help you to determine your RMD.
RMD Deadlines
If you’re taking an RMD for the first time, you must take it by April 1 of the year following when you turn age 70½. For example, if your birthday is on March 20, then you would turn age 70½ on September 20. In this case, your first RMD would need to be taken by April 1 of the following year. Following the initial distribution, subsequent RMDs must be taken by December 31.
RMDs from workplace retirement plans, such as 401(k)s and 403(b)s, work slightly differently than those from IRAs. Within a workplace plan, RMDs need to begin in the year you either turn age 70½ or retire, whichever is later.
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Plans Requiring RMDs
Most retirement plan accounts, including IRAs, 401(k)s, SEP-IRAs, profit sharing and other defined contribution plans, require annual minimum distributions. However, plans that provide for tax-free income at retirement, such as Roth IRAs and Roth 401(k)s, do not require minimum distributions.
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Compliance Rules
Any amount of an annual required minimum distribution that has not been withdrawn is subject to penalty. The IRS charges a 50% excise tax on any undistributed RMD amount. For instance, if your required minimum distribution amount is $1,000, and you only withdraw $700 by the deadline, the remaining $300 would be subject to a 50% penalty.
Dealing with Multiple Plans
If you have more than one retirement plan, you’ll need to calculate the RMD for each of those plans individually and then sum up those numbers to come up with a total RMD for the year. The amount of the RMD, however, can be taken from one or any combination of accounts within those plans to satisfy the withdrawal requirements.
For example, if you have an IRA and a 401(k), you would calculate the RMD from each plan individually based on age factors and the balance within the plan. Let’s say you calculate a $1,000 RMD from your IRA and a $1,000 RMD from your 401(k). The $1,000 RMD out of your IRA can be taken from any combination of accounts within the overall IRA, so long as a $1,000 total withdrawal is made. The same would apply to the 401(k).
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Withdrawing More Than the RMD Limit
IRS rules instruct that RMDs begin in the year an individual turns age 70½, but penalty-free withdrawals from retirement plan accounts can begin as early as age 59½. Once an investor reaches age 59½, she can withdraw any amount up to the full account balance without penalty. When that person reaches age 70½, withdrawals must begin, but the RMD is just the minimum that must be taken out. You can withdraw more than the RMD, but distributions can not be carried forward as future RMDs.
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Withdrawal Limits
The IRS rules for RMDs only apply to how much must be withdrawn each year. Retirement plan account owners can take as many transactions as they need to satisfy the RMD requirements.
The Bottom Line
Most tax laws are complicated to understand, and the rules around a retirement plan’s required minimum distributions are no exception. Thankfully, many financial services firms realize this, and are happy to step in to do the legwork for you. It is especially important to understand the rules around RMDs since the penalties for not withdrawing enough each year are steep. As always, consult a tax specialist if you run into any questions.
