Guide to Required Minimum Distributions

 By Robert Bartley

Running out of money in retirement is a very real fear for millions of aging Americans, and this fear is exacerbated by the necessity of taking Required Minimum Distributions. 

Making your money last through retirement is not only about saving a certain amount of money during your working years. It is also about developing a strategy for your retirement income that  takes into account your cash flow, tax obligations, and required minimum distributions. 

While you don’t want to have too little saved for retirement, you also don’t want to hoard your funds in an attempt to avoid the tax man. Having too much saved for retirement might seem like a ridiculous problem, but not properly utilizing your funds could create serious headaches. 

In this guide, we provide an overview of required minimum distributions – what they are, how to calculate them, and how they should factor into your retirement plan.

Tax-advantaged retirement accounts like traditional IRAs, 401(k) and 403(b) plans are great vehicles for everyday Americans to save for retirement. If you have a tax deferred retirement account, like a traditional IRA or 401(k), you’ll deposit funds into your account and get a tax write off for the amount that you contribute . The goal is to save money on taxes now and pay them later when you’re retired and in a lower tax bracket. If you expect to be in a higher tax bracket when in retirement, a Roth IRA is a better option, but you don’t need to worry about RMDs with a Roth. More on that later.

So, if the tax break comes when the money is withdrawn, why withdraw it at all? Wouldn’t holding out as long as possible and potentially passing money on to an heir make sense here? Yes, it would, but unfortunately the IRS doesn’t want you holding your retirement funds in perpetuity. Eventually you have to tap the account or face a penalty. These are called Required Minimum Distributions, or RMDs. Once you hit a specific age, you must distribute a certain percentage of the account each year. The amount you must take out depends on a variety of factors, but you’ll need to be conscious of this rule for tax considerations.

Up until 2019, RMDs began at age 70.5. But thanks to the SECURE Act, which passed right before the start of the pandemic, RMDs have been pushed back to age 72. You must take your first RMD by April 1st of the year after  you turn 72 and by December 31st for future years.. You’ll get hit with an RMD twice in a nine- month span if you wait until April 1st for that first RMD, so consider taking your distribution before then if you don’t want to be forced to withdraw that much cash in a short period of time.

Tax planning is very important. Taking two RMDs in the same year can push you to a higher tax bracket as well as a higher Medicare Part B premium bracket. However, if your income is high in the year that you turn age 72 but lower the next year, doubling up on RMDs in the second year could make sense.

Which accounts are subject to the RMD rule? Basically non-Roth IRA and anything that counts as a defined contribution plan, including profit sharing plans from an employer. Here are some of the most common retirement vehicles that have RMDs:

•     Traditional IRAs – When using a traditional IRA, the account holder can deposit up to $6,000 annually ($7,000 if age 50 or older) without paying taxes on it. Taxes are applied when the account is tapped in retirement, although funds can be withdrawn without penalty beginning at age 59.5. Anyone can open a traditional IRA and contribute, but the tax break goes away if you are an eligible participant of an employer sponsored retirement plan and your annual 2021 modified adjusted gross income (MAGI) exceeds  $76,000 (single) and $125,000 (married filing joint).
•     401(k), 403(b) and 457(b)Accounts – The 401(k), 403(b), 457(b) and traditional IRA have many similarities. You get an upfront tax break on your contributions and can begin tapping the funds without penalty at age 59.5. But unlike an IRA, a 401(k), 403(b) and 457(b) is an employer-sponsored plan, meaning it must be set up and administered by your workplace. The annual personal contribution limits are much more generous: $19,500 annually if you’re under age 50 or $26,000 if you’re 50 or older. Note that this is only the amount YOU can contribute from your salary; your employer can also contribute to the account. The maximum 2021 annual employee and employer contributions is $58,000 ($64,500 if age 50 or over).
•     SEP IRAs – A Simplified Employee Pension IRA is an employer-sponsored plan where the company sets up IRAs for each individual employee. Only the employer can contribute to these accounts; employee contributions are not allowed. SEP IRA contribution limits for 2021 are $58,000 ($64,500 if age 50 or over) or 25% of the employee’s salary, whichever is lower. Contributions are tax-deferred and can be withdrawn without penalty at age 59.5.
•     SIMPLE IRAs – Another IRS  acronym: the Savings Incentive Match Plan for Employees (SIMPLE) IRA. Designed for small businesses, the SIMPLE IRA allows both employees and employers to contribute (and in the employer’s case, contributions are mandatory).The maximum annual employee contribution for 2021 is $13,500 ($16,500 if age 50 or older).

The list above is an overview of small business retirement plans. We recently wrote a more detailed guide to small business retirement plans and their significant benefits to business owners.

Tax-deferred retirement accounts offered by nonprofits and government agencies  such as 403(b) and 457(b) plans also are subject to RMDs, but Roth IRA, 401(k), 403(b) or 457(b) accounts are not unless the account was inherited.

The IRS has a formula for determining what percentage of your account must be tapped each year to meet RMD standards. Although it’s not simple, it’s less complex than you’d expect from a government office. The IRS even has some handy worksheets to assist.

The two main factors that affect your RMDs are age and account balance. The IRS uses something called the Uniform Lifetime Table to calculate life expectancy rates and uses that as a basis for distributions. The process works like this:

1)    Calculate your account balance from December 31st of the previous year. You must do this for each individual IRA or account subject to RMDs.

2)    Use the IRS Uniform Lifetime Table to find your distribution period based on your current age, which will change annually. For example, the distribution period number for a 70-year old is 27.4 while an 80-year old has a number of 18.7.

3)    Divide your previous year’s account balance by the distribution period number in order to find your total RMD obligation for the year. For example, let’s say you’re a 75-year old with a $400,000 account balance. You’d take that 400,000 and divide it by 22.9, which is the distribution period number for a 75-year old.

400,000 / 22.9 = 17,467.25

In this situation, the 75-year old account holder would need to take a distribution of $17,467.25 by December 31st of that year. The distribution period numbers drop as age increases, with a low bound of 1.9 should you reach age 115. Most of us won’t be around to use the 1.9 divisor.  IRS Publication 590-B has more on the Uniform Lifetime Table and RMDs.

If you invest properly, historically the RMD would not deplete your account over your lifetime. In fact your account can continue to grow when the markets are doing well. Based on the new age 72 start date, your first year distribution amount is approximately 3.9%.

RMDs can create some hurdles for savvy savers when it comes time to paying taxes or planning your long-term income. From age 59.5 to age 72, your retirement accounts are yours to do as you please – you can take as much or as little as you want from the accounts. But once we turn 72, this control goes away as RMDs kick in.

What’s the biggest headache revolving around RMDs? Taxes. When living on a fixed income in retirement, minimizing taxes is crucial. But if RMDs aren’t planned for, you could wind up with a forced distribution that sends your income into the next tax bracket. Especially where you will also be collecting your Social Security retirement benefit. The RMD can make your Social Security income more taxable (yes, Uncle Sam charges you tax on your Social Security income). And since distributions from qualified accounts count as ordinary income, your tax bill could be quite high if you aren’t properly positioned. If you don’t plan and overpay taxes, you won’t recover that money and your lifetime income will decline.

Planning for RMDs doesn’t start at age 72! You must be cognizant of your tax bracket, account balances, and how much you’ll owe Uncle Sam on your distributions well before you actually have to start taking them so that you can plan how much to draw down your accounts over time and which accounts to withdraw from first.

Lastly, you should coordinate RMDs with when to start taking Social Security. It may seem counterintuitive but depleting your IRA account, and lowering later RMDs in order to let your Social Security benefit grow can be a smart plan. Why? If you have longevity in your family by deferring your Social Security benefit to a later age it will grow to a much higher benefit. The goal is to maximize all of your resources; investment accounts and Social Security, not just focus on one.

RMDs are unavoidable, but you don’t have to let them throw wrenches into your carefully laid financial plan. Just because you can’t avoid RMDs doesn’t mean you can’t limit the effect they have on your tax burden or income plans. Here are a few ways to lighten the load:

–       Reinvesting Distributions: RMDs can’t be put back into a tax-advantaged account, but you can use the proceeds to purchase tax-efficient investments in a taxable brokerage account. While this doesn’t reduce your tax burden in the present, it can help with complexities that arise from withdrawing funds when you still need those funds to keep generating additional wealth for you. Tax conscious investing such as buying index funds and municipal bonds can increase your nest egg while keeping your tax bill low.

–       Charitable Contributions: Donating your RMD to charity (a Qualified Charitable Contribution (QCD) can effectively reduce your income to 0, which means you won’t owe any taxes on it. If you can make ends meet through social security or other income and want to avoid taxes on your RMD, a charitable donation will do the trick while also aiding your philanthropic goals.

–       Backdoor Roth IRA Conversion: Here’s a popular one. Since Roth IRAs aren’t subject to RMDs and are taxed at the time of contribution (rather than at the time of withdrawal), you can use a Roth IRA to minimize taxes while also exerting greater control over when you withdraw your funds. But if your income is too high, you can’t open a Roth. You’ll need to rollover a sum from another retirement account into a Roth, which means paying taxes now. This maneuver, known as a backdoor Roth IRA, allows you to live comfortably while also minimizing taxes due to RMDs.

–       Utilizing Non-Required Distributions: There’s no rule that says you can ONLY take the RMD amount; you can always take out more. One common method of tax planning involves taking out enough cash to ‘fill’ your tax bracket up to the very next level. For example, let’s say your taxable income for the year was $60,000, which puts you in the 22% tax bracket for 2021. The 24% tax bracket starts at $85,525, so you’d have an additional $25,525 in ‘space’ under the 22% bracket ceiling. If you take out an additional $25,000, you’ll pay the same 22% rate on all your income and your RMDs in the future will be reduced since the account balance has shrunk. This strategy only makes sense if you have a use for the money. Otherwise you are paying taxes early and diminishing the tax deferred growth of this money.

–       Comprehensive Retirement Planning: Often, the best way to minimize your tax burden due to RMDs is to work with a qualified financial advisor. Retirement planning is a complex topic with many moving parts. The assistance of an advisor could pay for itself through the amount you save in taxes.

The penalty for not taking RMDs can be upwards of 50% on the amount you should have taken, so you’ll need to be aware of when and how much to withdraw once you hit age 72. But through retirement and tax planning, you can still maximize your nest egg funds while minimizing the amount you send to Uncle Sam. Contact your financial advisor today and learn how to make RMDs work in your favor.

If you’re interested in hiring a fiduciary financial planner to help you transition into retirement, manage cash flow, maximize your tax strategy, or meet any number of goals, then consider working with a fee-only financial planner like Bartley Financial, which has office locations in Andover, MA and Bedford, NH.

The Bartley Financial team provides financial advice that is tailored to the investment goals and objectives of their clients and informed by wealth of experience. At Bartley Financial, we are dedicated to delivering real value to clients, which entails adhering to high professional and ethical standards, as well as providing complete transparency when it comes to our fee-only financial planning for individuals and business owners.

Contact us today to learn more about how our services, philosophy, and fee structure can help you live the retirement you have dreamed of.