Here's What You Need to Know About Required Minimum Distributions and Taxes

By Maurie Backman Markets Fool.com

The beauty of retirement plans such as 401(k)s and IRAs is the ability to make tax-free contributions to your account and let that money grow tax-deferred until the time comes to withdraw it. But the money in your 401(k) or IRA can't just sit there indefinitely. In fact, once you turn 70 1/2, you'll need to start thinking about required minimum distributions, or RMDs. Your RMD is the mandatory minimum withdrawal you'll need to take from your retirement account, the exact amount of which is calculated based on your age and account balance. There are strict rules regarding RMDs, so you'll need to pay attention to them to avoid major penalties.

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Drawbacks of required minimum distributions

Many seniors who have retirement savings need to access that cash before age 70 1/2 to cover their living expenses. But if you're still working, or have another income source outside of your retirement account, you may not need to touch that money so soon.

The downside of RMDs is that once you reach 70 1/2, you have no choice but to start taking withdrawals. But since those withdrawals are treated as ordinary income, they automatically increase your tax burden. This can be especially problematic if you're still working at age 70 1/2 and earning a fairly high salary, because unless you have a large number of deductions, your RMD could easily bump you into an even higher tax bracket.

Calculating your RMD can be somewhat tricky, but it's important to get that number right. If you fail to take your withdrawal in full, you'll be assessed a 50% tax penalty on whatever amount you were supposed to take out but didn't. So if your RMD for a given year is $6,000 and you only withdraw $3,000, you'll lose $1,500 of that remaining $3,000 automatically. Ouch.

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Keep in mind that your initial RMD must be taken by April 1 of the year following the calendar year in which you turn 70 1/2. So if you turn 70 in January 2017, you'll need to take your RMD by April 1, 2018.

Another problem with RMDs is that they limit your assets' ability to grow. When you put money in a retirement account, the goal is to keep it invested so it continues to increase over time. Now once you've reached the age where RMDs come into play, you shouldn't have your savings invested too aggressively, because if you end up needing your money at a time when the market is down, you could lose out. But even once you shift into more conservative investments, you should still, ideally, be generating some sort of return on whatever money you're not using. But the more money you're forced to withdraw, the less you'll have available to grow into an even larger sum.

Avoiding required minimum distributions

RMDs can be a significant burden if you don't actually need the money. Thankfully, there are a few things you can do to avoid them. First, if you open a Roth IRA or 401(k) instead of the traditional version of each account, you'll avoid RMDs entirely. Roth accounts are funded with after-tax dollars, so there's no upfront benefit for contributing. However, when the time comes to withdraw money in retirement, those distributions are tax-free. Because Roth accounts don't impose RMDs, you can let your money sit and grow indefinitely.

You can also avoid 401(k)-related RMDs if you're still working at age 70 1/2 and don't own 5% or more of the company you work for. One you leave your job, those RMDs will kick in, but you can hold off on taking them until you're no longer employed by your company. That said, working into your 70s will only help you get out of RMDs from your 401(k); if you have an IRA, you'll need to take those RMDs regardless of your employment status.

Finally, just because you don't start out with a Roth account doesn't mean you can't end up with one. If you convert your traditional account to a Roth, you'll benefit from tax-free retirement income and the welcome absence of RMDs.

Because required minimum distributions can impact your taxes, taking steps to avoid them can help you save money at a time when you need it the most. Even if you can't avoid RMDs, you should still familiarize yourself with the rules surrounding them so you're not caught off-guard down the line.

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