What You Don't Know About Your IRA Could Cost You

By Maurie Backman Markets Fool.com

Not long ago, I reported on a study that revealed an overwhelming number of Americans are fairly clueless when it comes to IRAs. Some people, for example, don't realize that when you fund an IRA, you can invest your money as you see fit, while others don't know the key differences between a traditional and Roth IRA. But if there's one aspect of IRAs that you can't afford to be clueless about, it's required minimum distributions, or RMDs. And if you're not careful with yours, you stand to lose out -- big time.

Continue Reading Below

How RMDs work

The money you put into your traditional IRA can't just sit there and grow forever. Rather, you'll need to start worrying about RMDs once you turn 70-1/2. The amount of your RMD will ultimately depend on your account balance and life expectancy at the time, and you can use this calculator to figure out how much to withdraw. Once you arrive at a number, it's critical that you withdraw that amount in full. If you don't, you'll be assessed a penalty worth 50% of the amount you fail to remove from your account. In other words, if your RMD is $20,000 and you don't take it at all, you'll lose $10,000 right off the bat.

IMAGE SOURCE: GETTY IMAGES.

Your first RMD must be taken in full by April 1 of the year following the year you turn 70-1/2. If you turn 70 by June 30 this year, you'll need to take your initial RMD by April 1, 2018, or risk foregoing part of your savings to the aforementioned penalty. After that, you'll need to take your RMDs by Dec. 31 of each year going forward.

Now, if you have a Roth IRA, there's good news -- you don't have to worry about RMDs, because Roth accounts don't impose them.

Continue Reading Below

The trouble with RMDs

For a large percentage of retirees, RMDs don't actually pose a problem. The reason? Many seniors need to start tapping their nest eggs well before reaching 70-1/2, so withdrawing funds from an IRA is more of a necessity than an obligation. But if you have other sources of income, or are still working at 70-1/2 and don't actually need the money, you could face some aggravating tax consequences.

Unlike Roth IRA distributions, traditional IRA distributions are taxed as ordinary income. Once you start taking money out of your account, you not only cut into the growth potential of the vehicle, you're subject to taxes on whatever amount you remove. Talk about a double whammy.

But while taxes on RMDs are pretty much unavoidable, you're not actually required to spend the money you withdraw. Though you can't reinvest your RMD in another tax-advantaged account like a new IRA or 401(k), you can open a traditional brokerage account and keep growing your money that way. Will you face taxes on your investment gains? Yes, absolutely. But if you don't actually need the money to pay your living expenses, you can at least put it back to work, and hopefully snag a decent return.

Whether you're close to retirement or have many more working years ahead of you, you should be aware of your RMD deadlines and plan for them accordingly. You might also consider converting your traditional IRA to a Roth account to avoid RMDs entirely. Though doing so will increase your tax bill in the year you make the conversion, the long-term benefits of moving your money into a Roth IRA may more than make up for whatever short-term financial burden you incur.

The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.