When you save for retirement, focusing on accumulating wealth is only half the picture. Whether you are just getting started with your career or are close to retirement, it’s important to plan for the distribution of the funds you’re accumulating.
The federal government provides some powerful incentives for retirement savings, including tax deferral until you retire. However, in exchange for tax-deferred growth, savers can be required to pay taxes on the money they withdraw in retirement, which is where Required Minimum Distributions (RMDs) come in.
What Is a Required Minimum Distribution (RMD)?
Required Minimum Distribution refers to the minimum amount that retirees must withdraw from their retirement accounts each year once they reach a certain age, as mandated by the IRS. These withdrawals are required for traditional IRAs, 401(k)s, 403(b)s, and other tax-deferred retirement accounts, though Roth IRAs are generally exempt during the account owner's lifetime.
The IRS requires retirees to start taking RMDs by April 1 of the year following the year they turn 73 (regulations updated March 2023). After the initial distribution, subsequent RMDs must be taken by December 31 of each year. The amount of each RMD is calculated based on the account balance at the end of the previous year and a life expectancy factor set by the IRS. RMDs are subject to regular income tax.
Why RMDs Matter for Retirement Planning
RMDs have a significant impact on long-term retirement planning and cash flow, as they influence both the timing and amount of taxable income retirees must account for each year. Given that RMDs must be taken annually, they play a key role in shaping overall financial strategy in retirement, affecting taxes, investment growth, and spending.
Impact on Cash Flow and Income Strategy
RMDs add a predictable source of income, which can be beneficial for retirees who need cash flow to cover living expenses. However, they can also be disruptive if the funds aren’t needed for expenses, as the additional income from RMDs can push retirees into higher tax brackets, leading to larger tax bills.
Influence on Investment Growth
The need to withdraw from tax-deferred accounts to meet RMDs can impact the growth of retirement funds, as the withdrawals limit the amount of assets remaining invested. This may be a consideration for retirees who rely on their investment growth to fund their later years. Planning the timing and amount of withdrawals, potentially spreading them over the year rather than taking a lump sum, can help retirees maximize any potential gains in their accounts.
Legacy Planning and Roth Conversions
For those who want to leave a financial legacy, RMDs can influence decisions around converting a portion of retirement funds into a Roth IRA, where RMDs are not required. Roth conversions allow account holders to pay taxes upfront, reducing RMD-related taxable income later in retirement. This strategy can preserve more funds for heirs and minimize required withdrawals over the retiree's lifetime.
How to Calculate Required Minimum Distributions Correctly
Calculating RMDs accurately is crucial for retirees to ensure compliance with IRS requirements and avoid penalties. Here’s a guide on the correct methods for calculating RMDs, along with some common tools and resources to simplify the process:
Understanding the RMD Formula
The IRS calculates RMDs using a straightforward formula:
RMD = Account Balance as of Dec 31 of the Prior Year / Life Expectancy Factor
The life expectancy factor comes from IRS life expectancy tables, such as the Uniform Lifetime Table (for most account holders), the Single Life Expectancy Table (for beneficiaries), or the Joint and Last Survivor Table (for account holders with a spouse more than 10 years younger).
Tools and Resources for Accurate Calculations
Several online tools can simplify the RMD calculation process by doing the math for you. Here are some commonly used resources:
- IRS Website: The IRS provides free resources and guidance on calculating RMDs, including direct links to life expectancy tables.
- Financial Institution Calculators: Many banks, brokerages, and retirement account providers offer RMD calculators that allow you to enter your age and account balance to automatically calculate your RMD.
- Financial Planning Software: For those who manage their own retirement planning, many software products include RMD calculations alongside other planning tools.
Common RMD Mistakes to Avoid
When it comes to Required Minimum Distributions RMDs, retirees often face pitfalls that can lead to costly penalties or tax issues. Here are some of the most common mistakes to avoid to ensure smooth and compliant withdrawals.
Not Taking the Full RMD Amount
Failing to withdraw the full RMD amount is a common mistake with serious financial consequences. The IRS imposes a hefty penalty on any shortfall, charging a 25% excise tax on the amount not withdrawn by the deadline. This means that if you under-withdraw by $5,000, you could face a $2,500 penalty, plus the full amount of the RMD is still subject to income tax, increasing the overall tax burden.
Taking Distributions at the Wrong Time
One of the most common and most easily avoided retirement planning mistakes is not taking an RMD on time. You must take your first required minimum distribution no later than April 1 following the calendar year in which you turn 73. For subsequent years, you must take your RMD by December 31.
Calculating the Wrong RMD Amount
Withdrawing the wrong amount is another common error. Ensure that you’re using the available tables from the IRS to calculate your RMD amount correctly so you don’t face the consequences of working with the wrong number.
Not Optimizing Your RMD Strategy
If you have multiple IRAs, a TSP, SEP IRAs, or SIMPLE IRAs, you can aggregate your RMDs, meaning you calculate the RMD amount for each IRA separately but withdraw the total required amount from one or more of the IRAs. (This rule does not apply to 401(k)s or other employer-sponsored retirement plans, where you must take the RMD separately from each account.)
Aggregating IRAs allows retirees to manage their withdrawals strategically. As long as the RMD amount is correct, it doesn’t matter which account(s) you tap. You could pull all the funds from one single account or pieces of funds from multiple accounts, allowing you to draw from accounts with lower tax implications or different investment considerations.
Not Being Tax-Smart When Donating Your RMD to Charity
If you have more retirement income than you need, you may want to consider donating to your favorite charity. When planned correctly, you can avoid taxes on the funds you withdraw, and the money you donate will help a worthy cause, giving you and your favorite charity a double benefit.
When donating your RMD from an IRA, you’ll want to use a qualified charitable distribution (QCD). QCDs allow you to make a direct distribution to a charity that isn’t factored into adjusted gross income, thus lowering your tax bill. However, if you take the RMD and then write a check to your favorite charity, you will be taxed. If you do not have an IRA, you can transfer money, institution to institution, from a 401K or 403B to an IRA. These types of transfers are not taxed or penalized. However, they must be completed by December 31 of the prior tax year in order to have a balance from which to calculate an RMD/QCD.
You can choose to donate some or all of your RMD to charity. However, QCDs are limited to no more than $108,000 per spouse or $216,000 per couple annually for 2025.
Strategies for Avoiding RMD Mistakes
Here are some actionable tips and strategies to help you avoid common RMD pitfalls and ensure timely, accurate withdrawals.
Set Up Automatic Withdrawals
Many financial institutions offer automatic RMD services that can take the guesswork out of the process. By setting up automatic withdrawals, retirees can ensure that the correct RMD amount is withdrawn on time each year.
This minimizes the risk of missed deadlines and avoids the hefty 25% IRS penalty for under-withdrawals. Additionally, automatic withdrawals can be set to happen monthly, quarterly, or annually, giving retirees flexibility based on their cash flow needs.
Consult a Financial Advisor
RMD rules can be complex, and consulting a financial advisor can be invaluable in navigating these requirements. Advisors can help with accurate calculations, tax strategies, and determining which accounts to draw from for maximum tax efficiency.
An advisor can also provide guidance on timing RMDs to manage taxable income, potentially reducing the impact of RMDs on Social Security taxes and Medicare premiums.
Review Account Balances Annually
To ensure accurate RMD calculations, retirees should review their account balances by December 31 each year, which the IRS requires for RMD calculations. By confirming year-end balances, retirees can avoid mistakes from outdated or incorrect figures, ensuring they meet the exact RMD requirement.
Plan Roth Conversions to Reduce Future RMDs
For retirees looking to minimize future RMDs, converting traditional IRA funds to a Roth IRA may be a beneficial strategy, as Roth IRAs are not subject to RMDs during the account holder’s lifetime. While Roth conversions require paying taxes upfront, they can reduce the taxable income associated with future RMDs, potentially lowering taxes in retirement and preserving more funds for heirs.
AAFMAA Is Here to Help with Retirement Savings
If you have questions or need assistance planning for your financial future, we’re here to help! Contact us at 800-522-5221 to ensure your family is protected and prepared.
This article was originally published March 8, 2021.