Required Minimum Distribution Rules: Everything You Need to Know
Saving for retirement is critical if you want to enjoy your golden years. Fortunately, the IRS gives you some incentives to save for retirement by letting you invest through a variety of tax-advantaged retirement accounts. By using IRAs, 401(k)s, and similar accounts, you can get up-front tax breaks that reward you now for contributing to your future financial security, along with ongoing tax benefits that can save you thousands over the course of your career.
Eventually, though, the time comes to start taking money out of your retirement accounts. Rather than letting you keep money in these tax-favored accounts forever, the tax laws force you to start making what are known as required minimum distributions, or RMDs for short, from your retirement savings once you reach a certain age. The consequences of failing to take your RMDs are quite severe, so it's important to know not only whether the RMD rules apply to you but also how much money you have to withdraw from your retirement accounts in order to satisfy the requirements.
What is a required minimum distribution?
A required minimum distribution is an amount that the tax laws require you to take out of certain types of retirement accounts once you reach a certain age. If you have a traditional IRA, a 401(k) account, or any of several other types of employer-sponsored retirement plans, then you'll generally have to start taking RMDs once the provisions of the law kick in. The rules apply to certain inherited retirement accounts as well.
Required minimum distributions must be made in cash, and you're generally required to complete the withdrawal by the end of the calendar year. A one-time extension applies that gives you until April 1 of the following year to make what for most people is their first RMD (more on that in a moment), but after that, Dec. 31 becomes the deadline you'll need to pay close attention to in order to comply with the requirements.
Why do RMDs exist?
The reason the law forces you to take required minimum distributions has to do with the tax benefits that retirement accounts offer. With a traditional IRA, 401(k), or similar account, you get an up-front tax deduction for the amount that you contribute toward retirement. You also get tax-deferred treatment of any income and gains that the assets in your retirement account generate. That means no tax is due until you start making withdrawals. In other words, without RMDs, you could let your savings sit, untaxed, for your entire life. You could then pass those savings on to your heirs, who could pass it on to their heirs, and so on.
To understand this better, compare this favorable treatment to how regular taxable brokerage accounts get taxed. Typically, you'll have to pay taxes on the dividends you receive each and every year, and even at favorable qualified dividend tax rates, that can take 15% to 20% of your dividend income away from you off the top. When you sell an investment, you'll also have to pay taxes on any capital gains. If you hold an investment for longer than a year, then the top rates range from 0% to 20% depending on your income, but investments held for a year or less can cost you anywhere from 10% to 37% in taxes. Over time, those taxes can take quite a bit of money out of your retirement nest egg.
Lawmakers didn't like the idea of letting our investments go untaxed for generations, so they implemented RMDs, essentially putting a time limit on how long retirement savers can defer taxation. By forcing withdrawals, the RMD rules make retirement savers eventually pay taxes on their savings -- even if they don't really need the money at that point.
When do I have to start taking RMDs?
There are two main types of required minimum distributions, and each has its own rules on when RMDs must begin. If you're the original accountholder, then you'll need to start taking withdrawals in the year in which you turn 70 1/2 years old. Those who have just turned 70 1/2 in a given year have until April 1 of the following year to start taking their required minimum distributions. After that one-time extension, withdrawals in subsequent years must be made by the end of the calendar year.
If you've inherited an IRA, 401(k), or other retirement account, then slightly different rules apply. Spouses have the favorable option of being able to roll over inherited retirement accounts into IRAs in their own names, which simplifies things greatly going forward. However, others are limited to the few additional choices available to any heir: to take a one-time lump sum, to withdraw all money from the account within the first five years, or to take withdrawals stretched out over the course of their lifetime. This last option involves calculating RMD amounts for each year in order to ensure that the heir takes enough money out to satisfy the IRS.
With inherited IRAs, these rules take effect immediately -- so inheritors of any age have to take distributions. In other words, if you're an heir, you don't get to wait until age 70 1/2 with your inherited IRA before you need to start taking RMDs. Also, note that while the original owners of Roth IRAs are generally exempt from required minimum distributions, those who inherit Roth IRAs have to take RMDs in the same way as those who inherit traditional IRAs and other types of retirement accounts.
How big does my RMD have to be?
Calculating your required minimum distribution is the most challenging part of making sure you comply with the RMD rules. However, the basic idea behind the calculation is easy to understand. The goal of the IRS is to ensure that you withdraw all of your retirement savings over the course of your lifetime. Accordingly, it refers to life expectancy tables to help taxpayers figure how big each year's RMD needs to be.
Once you have all the necessary information, calculating your RMD is a simple three-step process:
- Add up the value of the retirement accounts that are subject to the RMD rules as of Dec. 31 of the previous year.
- Find the appropriate "distribution factor" by referring to the appropriate IRS life expectancy table that applies to your situation. (More on that below.)
- Divide the total retirement account balance by the distribution factor. The result is how much you'll need to withdraw for that given year.
Finding your distribution factor is where things get complicated. That's because there are multiple IRS tables that provide life expectancy estimates, and different tables apply to various situations. You can find them all in this IRS publication by searching for "Appendix B. Life Expectancy Tables" -- but this article reproduces the ones that most people end up using.
For your own retirement account, the most commonly used distribution factor table is the one below:
Typical RMD table for retirement accountholders
What this tells you is that if you're 70 years old, then according to the IRS life expectancy tables, you're expected to live another 27.4 years. So if you turned 70 1/2 in the last half of 2018, then to determine this year's RMD, you'd take your account balance as of Dec. 31, 2017. You'd then divide it by 27.4. The result would tell you how much you have to withdraw. The following year, you'd use your account balance as of Dec. 31, 2018 and the factor for 71-year-olds, 26.5. Divide the balance by the factor, and you'd have your RMD for 2019.
However, there are a couple of special cases. First, if you're married and your spouse is more than 10 years younger than you are, then there's a special table that has slightly different life expectancy calculations. Because the table needs to include not only your age but also the age of your spouse, it's far too long to duplicate here. However, you can find it by opening this IRS publication and then searching for Table II, the joint life and last survivor expectancy table. Here, too, you'll refer to the table over the course of your lifetime in order to figure out the new factor each year.
Also, if you're a beneficiary of an inherited retirement account, then a different set of tables applies. As mentioned above, those who inherit an IRA typically have to take RMDs regardless of their age, so the table covers everyone from newborns through centegenerians.
RMD table for beneficiaries of inherited retirement accounts
The rules for distributions for those who inherit IRAs are also different from the rules that apply to original retirement accountholders in that heirs only refer to this chart once. Thereafter, instead of using the new factor for your age the following year, you reduce the factor you used the previous year by 1. So for instance, if you inherited an IRA when you were 58 years old, you'd use the 27.0 factor for the first year of required minimum distributions. However, the following year, rather than using the 26.1 factor for 59-year-old people, you'd take 27.0 and subtract 1, getting 26.0 as the number by which you'd divide your account balance.
What happens if I fail to take my RMD?
Lawmakers were serious about forcing people to take required minimum distributions, so they made sure the penalties for failing to comply with the RMD rules were strict. If you don't take out the full amount of your RMD by the appropriate deadline, then the IRS charges a whopping 50% penalty on the amount that you should have taken out. Based on current tax rates, that penalty will be larger in every circumstance than the amount of tax you'd have to pay if you withdrew the required amount.
To some, the 50% RMD penalty seems draconian. But it only serves to express how important legislators found it to put limits on the amount of time that taxpayers could benefit from favorable tax laws surrounding retirement savings.
What are the tax consequences of RMDs?
The reason why many retirees don't like having to take required minimum distributions is that the tax consequences are the same as for any other withdrawal from a retirement account. For a traditional IRA, 401(k), or other employer-sponsored retirement account, the amount that you're required to withdraw is included in your taxable income for the year. In some cases, the extra income is enough to push you into a higher tax bracket, and that can affect how much tax you pay on other sources of income. For example, Social Security benefits become taxable when your countable income exceeds certain thresholds, and traditional IRA and similar distributions count toward those limits.
For those who inherit IRAs, the tax consequences of RMDs depend on the type of IRA in question. Traditional IRAs and similar retirement accounts are treated the same for heirs as for the original accountholders. Heirs taking RMDs from Roth IRAs aren't taxed on the distributions, so there's no increase to your tax bill. But having to take money out reduces the amount remaining in the Roth account, which in turn reduces the amount of tax-free income the Roth can produce in the future.
Some examples of how RMDs work
To make this clearer, let's take a few examples. In the first, say you're single, just turned 71 in October 2018, and had traditional IRAs worth $125,000 at the end of 2017. The appropriate factor for a 71-year-old is 26.5. So you'd divide $125,000 by 26.5, and you'd get $4,717. That's the minimum amount you'd have to withdraw in order to meet the RMD rules.
Now say that in the following year, your account has gone up in value to $130,000. You'll be 72 next year, so you'd look up the factor for 72-year-olds and divide $130,000 by 25.6. That gives you $5,079 as your 2019 RMD.
Now let's change the example somewhat so that instead of being single, you're married to a spouse who's 59. Because your spouse is more than 10 years younger than you, you need to look at the special IRS table for your situation. The factor here is 27.9, so dividing $125,000 by 27.9, you'd get a slightly smaller RMD of $4,481. The following year, the factor for spouses who are 72 and 60 is 27.0, so $130,000 divided by 27.0 = $4,815 -- again, slightly smaller than in the single case.
Finally, let's take an example in which you're 55 and inherited an IRA that was worth $125,000 at the end of last year. Looking at the table above, the first-year factor you'd use is 29.6, which produces a $4,223 required minimum distribution after you do the math. In the following year, rather than going to the table and looking up the factor for 56-year-olds, you'd just reduce the previous year's factor by 1. That yields 28.6, and $130,000 divided by 28.6 produces a 2019 RMD of $4,546.
Can I reinvest my RMD?
Many retirees have enough alternative sources of income that they don't really need the money they're forced to withdraw from their retirement accounts. For them, reinvesting would be an ideal option.
You're not allowed to reinvest your RMD back into your IRA or 401(k), nor are you allowed to take an RMD from one account and roll the amount over into another tax-favored retirement account. However, there's nothing stopping you from taking your RMD, depositing it in a taxable brokerage account, and buying exactly the same investments you held in your retirement account. You won't get the favorable tax treatment that an IRA or 401(k) allows, but you will continue to earn dividends and reap profits from any capital gains your investments make.
Know the rules
Finally, note that while the RMD rules force you to take at least a certain amount out of your retirement accounts, there's nothing stopping you from taking more than that. By the time RMDs kick in, accountholders are old enough to avoid early-withdrawal penalties, and there aren't any such penalties for those who inherit retirement accounts.
No one likes to pay taxes, so the required minimum distribution rules aren't always a favorite among retirement investors. However, it's critical to avoid the onerous penalties on those who fail to take their RMDs properly. By knowing the RMD rules, you'll be able to choose a strategy that lets you preserve the tax benefits of your retirement accounts for as long as you can without running afoul of the tax code and incurring stiff penalties.
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