The Basics of Required Minimum Distributions With Your Retirement Account

Retirement accounts like 401(k)s and IRAs allow individuals to save for their future in a tax advantaged manner. IRA and 401(k) contributions are often tax deductible and gains are tax deferred – meaning you may only pay taxes when you withdraw money from your account.

So, let’s say you contribute money to a traditional 401(k) plan in your 20s. Assuming you are eligible, you won’t pay taxes on the contribution or growth until you start withdrawing funds, likely into your 60s. This gives you ample time to grow your savings and investments for retirement.

The government, however, will eventually come to collect its taxes. IRAs and 401(k)s are primarily designed to help fund retirement not pass wealth onto future generations. As part of that, Congress established rules that require annual distributions from tax-advantaged plans once you reach age 72, 73 or 75. Recent changes in legislation have changed this age. Please see the chart below to identify your appropriate age, hereafter to be referred to as required beginning date (RBD).

Required minimum distribution (RMD) rules can be complex. In fact, even the RBD isn’t a hard and fast start in all situations as many factors determine when the RMD rules actually affect you. Let’s break down the basics of RMDs.

When Do RMDs Start?

RMD rules can be divided in two distinct categories: during an individual’s life and after an individual’s death. While an individual is alive, RMD rules generally apply after reaching RBD. In some cases, if you continue to work after reaching your RBD, you may be eligible to delay RMDs on certain accounts.

If you continue working for an employer past RBD and aren’t a “5% owner” of the company, you may delay your required beginning date for RMDs of that employer’s plan until you retire. For example, if your employer has a 401(k), you can delay RMDs until April 1 in the year after you retire. However, if you had an IRA on the side, or a 401(k) from a previous employer, it would be subject to RMD rules upon reaching RBD – with continued employment having no impact.

Planning Tip: If the 401(k) plan offered the ability to accept rollovers, you may consider rolling the IRA to the 401(k). RMD rules apply to the account the money is currently in – not where it used to be. So, rolling an IRA to a 401(k) while continuing to work past RBD may decrease RMDs until you retire.

After an individual dies, RMD rules for the inheritor generally apply in the year following the year of death. The RMD rules that apply to inherited IRA and 401(k) accounts are more complicated than the RMD rules applied during the account owner’s life.

To ensure one properly complies with RMD rules on inherited accounts, they must first establish a baseline of information:

• Was the decedent the original owner of the IRA?
• Did the IRA owner die before or after 2020?
• Did the IRA owner die before or after RBD
• What is the relationship between the beneficiary and the decedent?
• How old is the beneficiary?

Based on the answers above, beneficiaries are categorized into three types of beneficiaries known as Eligible Designed Beneficiaries, Non-Eligible Designated Beneficiaries, and Non-Designated Beneficiaries. Each of these categories have their own set of guidelines for calculating RMDs such as the 10-year rule (with and without annual RMDs), stretch RMDs in which an individual can base annual distributions on their own life expectancy, and so on. All of this is to say, there are a lot of moving pieces when inheriting an IRA. And let’s not forget a final category known as Successor Beneficiaries (inheritor of an inheritor) which has subcategories based on the timing and designation of previous inheritor.

Getting back to the owner of an IRA or qualified plan, RMDs are typically due by Dec. 31 each year. However, when an individual reaches their RBD, they will have until April 1 of the following year to take their first RMD.

It’s important to note, however, that delaying one’s first RMD until the following year may have tax implications as you must still take an RMD for the next year. For example, if you turned 73 on May 1, 2024, you would have until April 1, 2025 to satisfy your first (2024) RMD. You would also have an RMD due for 2025, which would be due by Dec. 31, 2025 – potentially causing you to draw two RMDs in the same calendar year. Going forward, each RMD would be due by Dec. 31 of that year.

Calculating RMDs

RMDs are calculated in a simple manner but there are details that you want to make sure you get right. To calculate the amount of your RMD, divide the previous year’s account balance by your life expectancy factor, which can be found on the IRS website.

Let’s say your 401(k) had a balance of $200,000 on Dec. 31, 2022 and you turned 75 in 2023. According to the IRS, your life expectancy is 24.6.  Therefore, the RMD that you will need to take by Dec. 31, 2023 can be found with the following calculation:

$200,000 / 24.6 = $8,130

Penalties for missed RMDs can be steep, varying from 10%–25% of the value of the missed RMD. Therefore, when taking RMDs it’s important to understand what accounts may be aggregated, and what accounts must satisfy their own RMDs.

If you have multiple 401(k) accounts, each must satisfy its own RMD. For example, if you had three 401(k)s, each owning a $1,000 RMD, you cannot take a $3,000 distribution from one account and satisfy the others.

IRAs, however, are different. Account owners may aggregate RMDs and satisfy from a single account. To use the example above, if you had 3 IRAs, each owning a $1,000 RMD, you may take a $3,000 distribution from a single account, satisfying the three individual $1,000 RMDs. However, IRAs may be aggregated for purposes of calculating your RMD. You then also have the choice of deciding from which IRA to take the RMD.

Why are the rules different for 401(k)s and IRAs? Why is the sky blue? Sometimes with tax code, it is better to not ask “why?”

It is important to note, when an individual inherits and IRA they can only aggregate the RMDs if the IRAs were inherited from one decedent. For example, let’s say you inherited two IRAs from your father, you may aggregate the RMDs. If, one year later, you also inherit an IRA from your mother, you cannot aggregate the RMD from your mother’s and father’s accounts.

What Accounts Are Subject to RMDs?

Determine what accounts RMD rules apply to. For the most part, your retirement accounts – ERISA-covered qualified retirement plans and IRAs – are subject to the rules. Qualified retirement plans include:

• 401(k)s
• Defined benefit plans
• Target-benefit plans
• ESOPs
• Stock bonus plans
• Cash balance plans
• Profit-sharing plans
• Money purchase pension plans

The rules also apply to traditional, SEP, and SIMPLE IRAs. Government plans and the Federal Thrift Savings Plan are also subject to RMDs once reaching RBD.

Beginning in 2024, Roth 401(k)s, Roth 403(b)s and federal Thrift Savings Plans allowing Roth contributions will no longer be subject to RMDs when the original account owner reaches RBD.

Roth IRAs present a unique counter option. When an individual is alive, they’re not required to take an RMD from their account. Roth IRAs are only subject to the RMD rules once an individual has passed away.

Your retirement account might be yours to save and spend, but rules dictate when you might have to tap into it. Understand how RMDs will impact your retirement and future income needs. It is also important to stay current on legislation that might affect RMDs as there have been several changes to RMDs recently.

Income Taxes and Rollovers

Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state income taxes.

Before rolling over your retirement account, consider all available options, which include remaining with your current retirement plan, rolling over into a new employer’s plan or IRA, or cashing out the account value.

When deciding between an employer-sponsored plan and IRA, there may be important differences to consider – such as range of investment options, fees and expenses, availability of services, and distribution rules (including differences in applicable taxes and penalties). Depending on your plan’s investment options, in some cases the investment management fees associated with your plan’s investment options may be lower than similar investment options offered outside the plan.

Talk to Your Financial Advisor

Speaking with a trusted professional can help to ensure you successfully navigate and prepare for RMDs. But don’t start a month before your first RMD is due. It’s ideal to plan years in advance of your first RMD so you can understand how and when to use your retirement plan balances in a way to get the most out of all your savings for retirement.

If you are looking for a financial advisor to help with your retirement planning, give us a call.