Required Minimum Distributions, or RMDs, affect IRAs in different ways that every retirement account holder should understand.

There are different types of IRAs, each of which has qualities that can be combined to benefit retirement savers. One critical difference between IRAs is whether or not they are subject to RMDs. A RMD is a set amount the account holder is required to withdraw each year, usually calculated as a percentage of the total funds held in the account.

RMDs don’t have to wreak havoc on your tax bill. If you have an IRA that is subject to RMDs, you’ll need to understand how RMDs work and their tax implications on your own personal finances, but you can also use a strong understanding of these accounts and taxes (as well as help from a qualified financial advisor) to make the most of these distributions.

What Are Required Minimum Distributions?

RMDs are cash sums you must withdraw from most retirement accounts beginning at age 72, or age 70.5 if your 70th birthday occurred before July 2019. RMDs apply to employer-sponsored accounts like 401(k) and 403(b) vehicles. RMDs also apply to traditional IRAs, SEP IRAs, and SIMPLE IRAs, but Roth IRAs accounts don’t have RMDs levied while the account owner is still living.

The main purpose of RMDs is to prevent retirement accounts from becoming legacy vehicles that allow taxes to be potentially pushed down the line forever. Since the account must begin drawing down once a year following the owner’s 72nd birthday, proper tax planning is an important step for retirees. Your RMD amount will vary each year depending on a specific RMD calculation table developed by the IRS. The formula will change again if you pass the account on to an heir.

RMDs must be taken by April 1st on the year after you turn 72 and then by December 31st each birthday after. The penalties for NOT taking your required amount are stiff. If you don’t withdraw the proper amount or skip the RMD altogether, you’ll owe a 50% excise tax on the amount you should have withdrawn. For example, if your RMD was supposed to be $20,000 and you only withdrew $16,000, you’ll have an extra $2,000 tacked on to your tax bill for the missing $4,000.

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How Are RMDs Calculated for IRAs?

To calculate your RMD amount each year, you’ll need to consult the IRS’s Uniform Lifetime Table to figure out your obligation. The table will list a distribution number which is used to calculate your RMD based on your age and account balance. Annual account balances are tallied on December 31st of the previous year. The account balance is then divided by the distribution number to find the total RMD amount needed.