Congratulations on making the smart decision to prepare for your financial independence! According to the U.S. Government Accountability Office, roughly half of households with individuals ages 55 and older have no retirement savings. Yes, we are referring to retirement accounts, such as a 401(k) plan or an Individual Retirement Account (IRA). These accounts are tax-deferred, meaning that you may receive tax benefits for your contributions, but when you withdraw from your account, distributions will be taxed at ordinary income rates – something that can be impacted by "required minimum distribution" (RMD).
Whether you are planning to contribute to a retirement fund for the first time or have been doing so for years, “required minimum distribution” (RMD) may be a term you’ve heard before but never truly understood. Investors don’t pay attention to it until they have to, which is often 30+ years after they first opened a retirement account. The sooner you understand the impact of RMD on your retirement assets, the more confidence you will have in your overall retirement income plan.
What Is Required Minimum Distribution?
Required Minimum Distribution is defined as the amount you must withdraw each year from your retirement plan account once you reach 70 ½ years of age.
Roth IRAs are the only type of retirement account that do not require age-related withdrawals. However, the death of the account holder requires a withdrawal from the Roth IRA. At that point, your beneficiary would receive funds from the inherited Roth IRA.
Required Minimum Distribution Calculator
The actual amount required for withdrawal from your account can be calculated using one of two available Internal Revenue Service (IRS) worksheets. The most commonly used three-step required minimum distribution worksheet includes an IRS life expectancy table, which will help you quickly determine the required distribution amount. Use the alternate five-step worksheet if your spouse is the sole beneficiary of the account and he or she is more than ten years younger than you.
The account holder is ultimately responsible for correctly calculating the distribution amount. For more information on this, publication 590-B provides full details of tax implications of distributions from individual retirement accounts.
Required Minimum Distribution Penalty
SEP (self-employed or small business owners) IRAs and SIMPLE (Savings Incentive Match Plan for Employees) IRAs can carry stiff penalties if you fail to make the correct and timely withdrawals as required. If the required minimum distribution is not taken on time or in the right amount, the amount not withdrawn is taxed at 50 percent.
Determining the required distribution correctly isn’t difficult, but can be tricky the first time. If you make a mistake, don’t panic. Use Form 5329 if this applies to your situation. Surprisingly, this penalty can be waived if there was an error made and corrective action has been taken to ensure that it does not happen again. Complete Form 5329 and attach a letter of explanation if you intend to submit a request for a penalty waiver.
How Much Is the Required Minimum Distribution?
The required minimum distribution amount varies.
The withdrawal amount is based on the account balance as of December 31st of the prior year and your life expectancy (aka Distribution Period) at the time of the necessary distribution.
If you own more than one retirement account, you will need to calculate the required distribution separately for each account. Generally, once the total required distribution amount is determined, you can decide whether or not you would like to make the withdrawal from one or more of those accounts.
401(k) Required Minimum Distribution
A 401(k) does require distributions to be taken separately. That is, if your required minimum distribution calculation for your 401(k) equals $2,000, then this is the amount that must be withdrawn from the 401(k).
Keep in mind that account holders can withdraw more than the minimum amount. However, an excess distribution cannot be applied in a future year’s required minimum distribution. Also, the surplus funds cannot be rolled over into another tax-deferred account. If you don’t need the money at the time of the required distribution, use those funds to open a new investment account if you’re intent on seeing your money grow.
Required Minimum Distribution – How to Plan Smart
Whether you started saving for retirement in your 20s or had a late start on your retirement planning, now is the best time to start planning for your future.
Since your first required minimum distribution must occur by April 1st of the year after you reach 70 ½, consider a few hypothetical scenarios related to your finances now to help you plan smart. If you keep investing at your current rate, determine what your required minimum distribution will be in the future.
You can perform a quick calculation using a hypothetical account balance and the Distribution Period associated with your age. For example, let’s say Samantha uses Table III (Uniform Lifetime) to determine her distribution amount.
Samantha’s 70th birthday is this March. She’ll be 70 ½ years old in that same year. Her IRA balance was $200,000.00 as of December 31 of the prior year. According to the calculation, she is required to withdraw $7,299.27.
$200,000.00 / 27.4 = $7,299.27
Required minimum distribution amounts will vary each year.
If you inherit an IRA, as the beneficiary you must use Table I (Single Life Expectancy) to determine required minimum distribution amounts. Several factors determine how the distribution is calculated:
- Date of account holder’s death (before or after the required beginning date of distribution)
- Relationship of account holder to beneficiary (spouse, non-spouse, estate, charity, etc…)
- Number of beneficiaries named by the account holder for the IRA
Each relationship requires the beneficiary to make choices that will ultimately determine how to perform the calculation. If the account holder passes away before the required beginning date of distribution, no distribution is required in the year of the account holder’s death. The calculation rules required for each scenario vary and should be reviewed carefully.
For example, surviving spouses who are designated as the sole beneficiary of the deceased spouse’s IRA are permitted to treat the account as their own. By doing so, surviving spouses may determine the required distribution (if any) beginning the year of ownership designation.
Different scenarios present alternative distribution options. Beneficiaries should know they have been named on the account as soon as the designation occurs since there will likely be tax consequences for account withdrawals. Educating yourself and your beneficiaries now may help you decide if you should increase your current contributions or adjust your overall retirement plan.
As you can see, there are many considerations that go into determining RMDs for various types of accounts. For additional guidance, consult a CERTIFIED FINANCIAL PLANNER™ professional in your area to help you figure out your options and ensure you’re on the right track.