Retirement accounts like 401ks and IRAs can be incredibly valuable, allowing you to shelter your earnings from Uncle Sam. But unfortunately, this does not last forever. There is something called required minimum distributions (RMDs) that forces you to start withdrawing funds when you turn 70 1/2.
In fact, you must do this for every year for the rest of your life. And the oldest baby boomers are now starting to reach RMD territory, so if you're not up on the rules … you'll really want to read along.
The IRS has a formula for calculating RMD that is based on your life expectancy, which also includes your spouse's. The RMD percentage generally starts at about 3.7% and increases a small fraction every year.
And the IRS collects a whopping 50% penalty on funds that have not been withdrawn, so it's vital you know the ins and outs of this requirement.
Important Aspects of Required Minimum Distributions (RMDs)
First off, it's important to know when RMDs apply, and when they don't.
- Required minimum distributions do apply to traditional IRAs, SEP-IRAs, Simple IRAs, 401ks, profit-sharing plans and 403bs.
- Required minimum distributions do not apply to Roth IRAs, because contributions are made with after-tax dollars. So you can keep your money in a Roth IRA for as long as you want.
- If you have a 401k or 403b and continue to work after you turn 70 1/2, you don't have to take RMDs. However, if you're the owner of a business that sponsors your retirement plan, that exception doesn't apply.
The deadlines can be tricky, too.
In the year you turn 70 1/2, you do not have to take an RMD until April 1 of the following year. However, in every year after this, you must take a required minimum distribution by Dec. 31. If you do opt until April of the following year for your first distribution, you'll need to take two RMDs for the year. However, if you do this, you could push yourself into a higher tax bracket (RMDs must be recognized as ordinary income, not long-term capital gains), have more of your Social Security benefits taxed and lose various tax deductions and credits.
It's also a good idea to start preparing a few weeks before the deadline, as the paperwork can be time-consuming.
And what if you miss the deadline? Well, there is that penalty to deal with, but you can try to get a waiver by filing Form 5329 and providing an explanation of your situation.
How Much Will Your RMD Be?
You can calculate your required minimum distribution via software like Intuit Inc. (NASDAQ: INTU ) TurboTax or IRS Publication 590-B. The RMD is based on the value of your retirement account as of Dec. 31.
But things get more complicated if you have different accounts.
For example, if you have multiple 401k accounts, you need to take an RMD from each. But if you have multiple IRAs or 403b accounts, you can take RMDs from one, some or all - so long as the amount meets the total minimum requirement.
Definitely contact your financial adviser if you have multiple accounts … and maybe consider consolidating all your retirement accounts into one IRA.
When you take an RMD, it is important to calculate your taxes and set them aside. You may also want to make quarterly estimated payments.
You can do whatever you want with the after-tax money - take a vacation, buy a boat, what have you. But you can reinvest it. One strategy is to set up a Roth IRA, which can be an effective way to transfer assets to your heirs.
There are also other sophisticated strategies that could result in lower required minimum distributions, such as QLACs (qualifying longevity annuity contracts) or Qualified Direct Transfers (QDTs).
My advice for anyone is to seek out professional advice on your RMD obligations, but you certainly should ask for professional help if you're considering advanced strategies.
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