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What is a required minimum distribution and how can this caveat help you save more for retirement?
Disclaimer: The information provided is not intended as tax or legal advice and may not be relied on for purposes of avoiding any federal tax penalties. Individuals are encouraged to seek specific advice from their personal tax or legal counsel.
Having a solid plan in place to enjoy our golden years is something that demands a lot of time and commitment decades before we’re even reaping the benefits of our diligence. It requires a lot of thought, budgeting, investing, and consistency to master. A well-built nest egg is not something you just stumble into.
Of course, there are a lot of I’s to dot and T’s to cross in order to avoid any missteps along the way, and to follow your plan successfully.
One of the most often overlooked aspects of those details is required minimum distributions, or RMDs. RMDs are a must-know principle of retirement investing, and something to plan for long before reaching the point where you’ve got to start withdrawing.
The story of RMDs
Most retirement accounts (aside from their Roth relative) are tax-deferred accounts, meaning your contributions go into the account pre-tax, and you’ll owe taxes upon withdrawal on that contribution and the growth in retirement.
Because of this, the IRS wants to protect itself against a potential loophole. Suppose an account holder elected to never withdraw from their tax-deferred retirement account. In that case, they could theoretically never pay any taxes on their assets before passing it on to their heirs. Enter: Uncle Sam coming to collect.
As a result, the IRS created the required minimum distribution in lockstep with these tax-advantaged accounts to prevent that from happening.
Details of the RMD rule
When: After you reach the IRS required age, you must begin taking your required minimum distribution. As of 2024, the RMD age is 73, but is subject to change by the IRS.
How much: The amount you’re required to withdraw annually is calculated by accounting for your date of birth, account balance, and the life expectancy factor, which is a number ranging from 27.4 at age 72 to 2.0 at age 120.
The method: You can withdraw your RMD in a few various options, whether a lump sum payout or consistent distributions throughout the year. If you have multiple retirement accounts that require an RMD, the way you structure your withdrawals depends on the account type. If you own multiple IRAs, for example, the withdrawal can typically come from one account to cover the total obligation; however, for 401(k)s, the withdrawal must come separately from each 401(k).
Penalties: Failure to take your RMD will result in a hefty tax penalty of the amount you were required to withdraw. A little planning can help you avoid this nuisance.
Account types: Essentially all employee-sponsored tax deferred retirement accounts like 401ks and 403bs, and IRAs, are subject to the RMD rule.
How RMDs impact your retirement
How does the RMD rule play into your retirement planning? Well, that depends a lot on your situation. If you’re like most retirees and plan to at least somewhat rely on your retirement accounts for cash flow, then worrying about your RMDs will likely be a non-issue for you.
However, if you’ve done exceedingly well at saving for retirement and have several accounts stuffed to the brim, then keeping an eye out for when your RMDs have to occur, will be a part of your retirement reality.
Fortunately, RMDs aren’t too difficult to handle. All you’ll need to do is ensure you accurately calculate how much you’ll be required to withdraw annually once you reach that golden age, and then execute the withdrawal one time every year—maybe even a little less than every 12 months, just to be safe. Most broker dealers will reflect the amount of the RMD on your statements as well as what you've taken out toward that RMD each year.
Minimizing an RMD impact
If you still want to minimize the impact RMDs have on your retirement savings, you have a couple of options.
Convert to a Roth IRA
Converting your account to a Roth IRA will trigger a tax bill on the conversion, but any gains or withdrawals after the fact will continue to grow tax, and RMD-free. This can make a ton of sense if you are doing the conversion in a year where you have an exceptionally low tax bracket.
Donate the RMD to charity
If you’re in a position where you have to remind yourself to take your RMD, there’s a good chance you don’t need the cash flow. If that’s your situation, donating your RMD to charity can help offset your overall tax obligation for the year, easing the blow of the taxes owed on that withdrawal.
Sell select holdings
If you complete your RMD automatically, as many people do, you could end up having to sell assets you don’t want to sell, to be able to fund your withdrawals. By going for the manual process, you can choose to sell less of your better-performing assets, and maybe even pull entirely from cash if your account's assets hold enough to cover it.
Planning is key
Ultimately, the key to successfully navigating the world of RMDs and using them to your advantage comes from planning ahead. It’s never too early to start thinking about the future, and the younger you get started on a retirement plan the better.
Once you have a good idea of where you’ll financially be as you near retirement, you can begin budgeting and taking actionable steps to plan for your RMDs, and potentially avoid or minimize the impact those taxes have on your investments.
People don’t just read about RMDs for fun, so the fact that you’re here indicates you’re well on your way to financial wellness. But that doesn’t mean there’s not always room to improve, right? This is your friendly reminder to keep a check on your to-do list items in your app, review your transactions, and peep your cashflow—it’ll only take 3 minutes each week!