Another day, another acronym. The financial industry is rife with them, causing cringes, confusion, and avoidance, so I try to assume the mantle of translator from time to time. RMD is an important term to know, particularly if you’re approaching retirement, or if you’re already in the thick of it. RMD stands for Required Minimum Distribution, and it is the amount that the IRS requires you to withdraw from your tax-deferred retirement accounts when you turn 70 ½. Tax-deferred retirement accounts include qualified defined contribution plans (401(k)s, 403(b)s, 457s, and Thrift Savings Plans), as well as the basket of IRAs (Traditional, Rollover, SEP, and Simple). (There is one conspicuous exception in the lineup here – RMDs are not required for Roth IRAs since they are funded with after-tax money and therefore are not tax-deferred.) The catch here is that the RMD is tax-deferred money, so you will be liable for taxes on it at ordinary income rates.
There are two options for when you can take your first RMD. The first option is to take it anytime in the year that you turn 70 ½. The second option is to take it by April 1 of the year after you turn 70 ½. Initially, the second option seems like a boon, as it delays the administrative work and the tax hit into the following year. However, doing this can cause a much higher tax bill the following year, as you will also need to take your second RMD that same year. The result could even push you into a higher tax bracket, which should be avoided if possible.
A common question is, what happens if I have a motley crew of retirement accounts, do I have to take a separate RMD for each account? Well, you can combine all your IRA account balances and take one RMD from one of the IRAs, and combine all your 403(b) account balances and take one RMD from one of the 403(b)s, but if you have another kind of qualified defined contribution plan like a 401(k), you have to take the 401(k) RMD from that account only. So the answer is yes, aggregation is possible, but it depends on the account type.
If you’re still working at age 70 ½, your qualified defined contribution plan may allow you to defer taking your RMD until you actually retire, so it is worth checking with your plan administrator about this. It is generally prudent to continue realizing the benefits of tax-deferred compounding until you have to stop. If you’re still working at age 70 ½ and own more than 5% of the business, you can’t defer taking your RMD until retirement. Furthermore, your ownership can be attributed to your spouse and/or children also employed by that same business, and can prevent them from deferring their RMDs until retirement as well.
If for some reason (including but not limited to the cringes, confusion, and avoidance mentioned above) you missed the deadline to take an RMD, the IRA penalty is particularly harsh – 50% of the amount that you owe for the RMD. For example, if your RMD is $5,000, you would owe the IRS a hefty $2,500 (plus the tax you owe on the RMD itself). Of course, this money would be much better spent on… almost anything else.
How are RMDs calculated? Turns out it’s not an onerous process of sifting through IRS tables or identifying correct distribution factors, as the Internet is benevolent. I like Charles Schwab’s online RMD Calculator, which is simple and user-friendly. All you have to do is input your account balance as of 12/31 of the previous year, your date of birth, your primary beneficiary and their date of birth, and the rate of return you expect to receive on the account, and ta-da your RMD is calculated. The last thing to note here is that you are not limited to the RMD amount at any time – you can take out as much as you want, even the whole ball of wax. The piper – ahem the IRS – certainly won’t stop you as they are happy to collect the taxes whenever you are ready to pay them.