IRAs let you get tax advantages throughout your career, but the lawmakers who created traditional IRAs didn't want people to have the benefit of tax deferral forever. They therefore put in provisions that force retirees to take required minimum distributions once they turn 70 1/2. These RMDs apply to both traditional IRAs and workplace retirement accounts like 401(k)s, and if you don't take out enough money, then you'll owe a potential 50% penalty to the IRS on the amount you improperly left in the IRA. Figuring out exactly how much you need to take out can get complicated, but you'll find the help you need below.
Continue Reading Below
In order to figure out your required minimum distribution, you need two numbers. First, you need your account balance in your retirement account as of the end of the previous year. Second, you need to know your age, because it in turn will help you determine the appropriate fraction of your retirement funds that you need to withdraw. The IRS provides tables to help with the final step.
For instance, say that you had $250,000 in your IRA and will be age 72 as of the end of 2017. To calculate your RMD, you'll take the $250,000 balance and then divide it by the appropriate age factor from the IRS, which in this case is 25.6 years. Doing the math, that makes your required distribution $9,766.
Typically, you have until Dec. 31 to take your RMD. For the tax year in which you turn 70 1/2 only, you can wait until April 1 of the following year before taking your required minimum distribution.
This illustration also shows the consequences of not taking an RMD. The IRS imposes a penalty of 50% on money you should have taken out of an IRA or other retirement account. Here, that would result in a $4,883 penalty -- a harsh tax bill for neglecting a simple requirement.
Continue Reading Below
Image source: Getty Images.
The long-term impact of RMDs
What required minimum distributions do is to whittle away slowly at the value of your retirement account over time during your retired years. The calculator below gives a longer-term picture of the impact that RMDs have on your nest egg.
Editor's note: The following text is provided by CalcXML, which built the calculator below.
* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.
Again, take the example above, filling in a birthday of Dec. 31, 1945, a nonspouse beneficiary, an account balance of $250,000, and anticipated returns of 5% annually. When you run the report, you'll get a graph that shows steadily increasing total balances until age 79, because the 5% growth assumption exceeds the RMD amount. After that, RMDs get larger than income, but the RMD amount itself keeps growing because your life expectancy gets shorter. Only at age 94 do your RMDs start getting smaller.
What to do if you don't like RMDs
If you're not happy about required minimum distributions, there are a couple of things you can do. First, with respect to your current employer's 401(k) plan only, you don't have to take RMDs if you're still working even if you've already reached age 70 1/2. Even if you're still working, however, you have to take RMDs from your IRAs and from any 401(k) money you have at an old employer.
The other solution is to use Roth IRAs rather than traditional IRAs. For whatever reason, the laws that created Roth IRAs didn't choose to include an RMD requirement, and so you don't have to take required minimum distributions from a Roth. Instead, you can let your money grow indefinitely until you absolutely need it.
Retirement accounts have great tax advantages, but all good things must come to an end. By knowing and following the RMD rules, you can ensure that you won't get snared by a draconian tax penalty.
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.