Like it or not, there are ample opportunities to derail your finances in retirement. You could, for example, neglect to create a budget, get penalized for enrolling late in Medicare, or take on costly credit card debt at a time when you'll most likely struggle to pay it off. But if there's one mistake you really don't want to make this year, it's neglecting your required minimum distribution. And unfortunately, nearly 50% of seniors are at risk of doing just that.
How required minimum distributions work
Continue Reading Below
If you're new to the world of required minimum distributions, or RMDs, here's a quick rundown. Any time you have money in a traditional IRA or 401(k), you're required to withdraw a certain amount on a yearly basis once you turn 70 1/2. The actual amount of your RMD will depend on your account balance coupled with your life expectancy.
Now, some seniors don't mind RMDs because they're already withdrawing funds from their retirement accounts regularly and thereby meeting the requirement. But for those who have another source of income -- whether it's a business venture or a different set of investments -- RMDs can be not just a nuisance but also a tax-related hassle. That's because money withdrawn from a traditional IRA or 401(k) is taxed as ordinary income, so if it's not cash you need, then frankly, it stinks to have to pay taxes on it. Furthermore, once you withdraw that money, it can no longer grow in a tax-advantaged fashion (though you can reinvest it in a traditional brokerage account and gain additional income that way).
What happens if you don't take your RMD? It's simple: You'll be slapped with a 50% tax penalty on any amount you fail to withdraw. This means that if your RMD for the year is $5,000, and you don't take it in time, you'll lose $2,500 of your savings, just like that. Talk about a harsh blow.
Though countless seniors are subject to RMDs, there are a few ways to avoid them. First, if you save in a Roth-style account, as opposed to a traditional one, you'll have the option to leave your money in there indefinitely. Remember, unlike traditional retirement accounts, Roth accounts don't offer an immediate tax break for contributing, so they're more flexible when it comes to reaping benefits down the line.
Furthermore, if you have a traditional 401(k) but are still working for its sponsoring company by the time you reach 70 1/2, you can hold off on taking RMDs until you leave that job (assuming you don't own 5% or more of the company). But if you hold a traditional IRA, you can't get out of those RMDs even if you are still working at the time.
Withdraw your money while you can
It's natural to wait until the end of the year to take your RMD because the more you hold off, the more you get to benefit from potential gains on that money in your retirement account. But don't wait too long to make that withdrawal -- because if you don't receive your RMD by the time 2017 comes to a close, you'll be hit with the nasty penalty we talked about earlier.
Fidelity reports that nearly half of its 970,000 IRA customers have yet to take their RMD for the current year, so if you're in that camp, make a note on your calendar to withdraw your money before it's too late. After all, you worked hard to save that cash, and you probably need it to cover your living expenses. The last thing you want to do is forgo a huge chunk of your savings for no reason other than neglect or poor timing.
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.