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Don't retire until you know these 4 facts about RMDs

The Motley Fool logo The Motley Fool 3/15/2019 Rita Williams
Piggy bank with "RMD" on side.© GETTY IMAGES Piggy bank with "RMD" on side.

The government has generously built certain tax advantages into retirement accounts like traditional Individual Retirement Accounts (IRAs) and 401(k)s. And you should be socking away as much as you can and strategically using these accounts to plan for your financial future.

But eventually, the Internal Revenue Service (IRS) wants a bite of your savings, and it accomplishes this through something called required minimum distributions, or RMDs, that kick in when a saver reaches age 70 1/2, and then happen annually. Anyone with a retirement account needs to know about RMDs, including the giant penalty for not following the rules, the annual deadline for taking them, their tax treatment and how to find how much your RMDs will be.

1. Penalties for not taking your RMDs are very steep

If you have a traditional IRA or 401(k), you can take withdrawals from it starting at age 59 ½. But when you turn 70 1/2, the IRS mandates that you withdraw a certain amount of money, your RMD, each year from these traditional accounts. If you don't take an RMD at that age, the IRS will assess a whopping penalty: 50% of the amount you should have withdrawn. You've spent a long time saving for retirement; you don't want the IRS to take a haircut that steep.

It helps to understand the penalty from the IRS's point of view. RMDs are required of retirement accounts whose contributions are tax-advantaged in the year of contribution. Contributions to traditional IRAs, for example, are tax deductible in the year of contribution. Contributions to 401(k)s are made with pre-tax money, so are not taxed until withdrawal. The IRS gives you these tax advantages as an incentive to save for retirement. But, eventually, yes, it's going to want some of that money back. That's why Roth IRAs, whose contributions are not tax deductible in the year of contribution, don't have RMDs. You can let a Roth IRA sit as long as you wish without withdrawing funds. 

You must take your RMD by December 31 of each year, with an important exception we'll explore later on.

2. RMDs can be paid out in a lump sum or incrementally

Although you have to take RMDs, the way you can take them during the year is flexible. You can choose to receive your yearly RMD in a lump sum, or have it paid incrementally throughout the year.

If you have multiple 401(k)s and IRAs, you are not required to take an RMD from each account. You can take the total from one or two accounts (or however many you choose), as long as you take the overall total amount required. It's the RMD on your total amount subject to RMDs that matters, not number of accounts.

It's helpful to know what your RMD is when making this decision. Calculating RMDs can be somewhat complicated. Most financial institutions will do it for you, although you may have to ask.

If you want to do it yourself, here's how: Total your account balances in all accounts subject to RMDs, at the end of the year. Then, find your life expectancy in the IRS's Uniform Lifetime Table. (If you have an account in which your spouse is the sole beneficiary, and your spouse is more than 10 years younger than you, use the IRS's Joint Life and Last Survivor Expectancy Table instead. It can be found in IRS Publication 590-B.) Then, divide the total of all balances by the relevant life expectancy factor in the table you used: That's your RMD for the year.

3. RMDs are taxable income, thus impacting how much you pay in taxes

The money mandated you withdraw is taxable income and will be taxed like any distribution from a retirement account and is included in your taxable income for the year you take it.

The RMD amount could be enough to push you into a higher income tax bracket the year you take it. This could also affect the taxation of your Social Security benefits, because Social Security becomes taxable if your income rises above certain limits.

You have until December 31 of every year to take that year's RMD, with one exception: The year of your first RMD, the deadline is April 15 of the following calendar year. In other words, if you will turn 70 1/2 in 2020, you have until April 15, 2021 to take your first RMD.

A caveat is that exercising this option could add to your tax burden in that year, because you effectively take two RMDs in one tax year. If you take your first RMD in April 2021, it counts as taxable income for 2021, but so will your second RMD, which you'll have to take by December 31, 2021. Two RMDs in one year may put you into a higher tax bracket, and affect whether your Social Security is taxed, so be sure to calculate the most advantageous time to take your RMD each year.

4. The money can be reinvested

Some retirees are reluctant to take RMDs at 70 ½, because they'd prefer to continue letting the money grow in the market, for a myriad of reasons. Some retirees have sufficient sources of income for now. Some people may want to keep saving for a later retirement. There's no way around RMDs, but you can invest the money back in the market once you get it out of your retirement account.

Invest the funds into taxable funds, such as a brokerage or investment accounts. You can't put them back into a tax-favored retirement account, such as an 401(k) or IRA. (In other words, you can't turn around and reinvest what you withdrew in the same accounts or similar ones.) But if you like the investments you have, there's nothing stopping you from recreating the holdings that you once held in your 401(k) or IRA in a taxable brokerage account.

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