Making Sense of Required Minimum Distributions

Making Sense of Required Minimum Distributions

Required minimum distribution rules are confusing, and, unfortunately, the penalty for failing to take the correct distribution is severe. We help you understand your obligations and show you how to use your RMD to pursue your financial goals.

Published by Motley Fool Wealth Management Originally posted on Tue, Sep 27, 2022 Last updated on September 27, 2022

read time 6 min read

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The government wants you to save for retirement. That’s why many people believe the most beneficial savings vehicles available are retirement savings accounts. Yup, your 401(k) and IRA are designed to encourage you to save for your later years.

But, the government also wants you to use that money while you’re alive and not give it to your heirs after you pass. So they make you take a distribution each year—a required minimum distribution (RMD)—when you reach 72 years old.

But (with many things designed by the government!) required minimum distribution rules are confusing, and, unfortunately, the penalty for failing to take the correct distribution is severe.

Fear not; we’re here to help you understand your obligations and show you how to use your RMD to pursue your financial goals.

What Are Required Minimum Distributions (RMDs)?

RMDs are the minimum amount that retirement account owners must take out each year. You can withdraw more if you’d like, but you need to take the minimum amount at the very least. And RMDs are taxed as ordinary income.

Which accounts do RMDs apply to?

RMDs must generally be taken from any tax-deferred retirement account. The most common accounts that mandate RMDs are: 

  • Traditional IRAs
  • SEP IRAs
  • 401(k) plans
  • 403(b) plans
  • 457(b) plans

How Is Your RMD Calculated?

Your minimum distribution is calculated based on the end-of-year balance of your retirement account and a life expectancy table published by the IRS.1 As you age, your life expectancy decreases, and your RMDs increase.

Though the RMD is calculated separately for each IRA, you can take the total amount from a single IRA if you prefer. However, RMDs from most employer-sponsored retirement accounts and beneficiary accounts must be calculated and taken separately.

When is the deadline to receive your RMDs?

You have to take your first RMD by April 1 of the year after you reach the age of 72. For every year after that, you must take the RMD by December 31 of the year.

Congress is currently considering bills that could change the age requirements for RMDs. The SECURE Act, which was passed in 2019, changed the age from 70 ½ to 72. Now SECURE Act 2.0, which was passed by the House in March 2022, proposes changing the age according to this schedule:2

  • Age 73 for people who turn 72 after Dec. 31, 2022, and 73 before Jan. 1, 2030
  • Age 74 for people who turn 73 after Dec. 31, 2029, and 74 before Jan. 1, 2033
  • Age 75 for people who turn 74 after Dec. 31, 2032

In June 2022, the Senate passed two similar bills, The Enhancing American Retirement Now (EARN) Act and the Retirement Improvement and Savings Enhancement to Supplement Healthy Investments for the Nest Egg (RISE & SHINE) Act. The House and Senate versions must be reconciled before a final bill is passed. Many hope one will be passed and signed into law by the end of the year.

What happens if you don’t take RMDs?

RMDs define the minimum amount you need to take each year. You can always take out more! But, if you do withdraw more than your RMD, you cannot apply any excess to future years.

The penalty for failing to take out enough to satisfy your RMD or failing to withdraw your RMD by the deadline is a 50% tax on the undistributed portion.

That penalty, however, may be waived if you can prove that the shortfall is due to a reasonable error and you are taking the necessary steps to fix the issue. The SECURE Act 2.0 proposal would reduce the penalty to 10% or 25% as long as you fix the situation in a timely manner.3

How Will Your RMD Affect Your Tax Situation?

RMDs are generally treated as ordinary income and will be taxed at your income tax rate. From a tax perspective, it doesn’t matter whether you take your RMD earlier or later in the year. However, if you’re interested in reducing your tax burden when taking your RMDs, there are some strategies you can use.

  •  Qualified Charitable Distribution. Transfer your RMD to charity tax-free by making charitable donations through a Qualified Charitable Distribution (QCD). You must be over 70½, and it must be paid directly from your IRA to a qualified charity. There's also a maximum amount that you can donate through a QCD. 
  • Backdoor Roth IRA. Rollover your retirement account into a Roth IRA. While you don’t have to receive RMDs from a Roth IRA, in the year you do a rollover, you must pay taxes on the amount you transfer. There are income rules around Roth IRAs, and the tax bill may be substantial, so you should talk to a wealth advisor before you decide to do this.
  • Continue working. Postpone RMDs from a workplace retirement account if you are still working. However, you will need to take them from your IRAs or if you own 5% or more of the business sponsoring your retirement plan.
  • Qualified Longevity Annuity Contract. Purchase Qualified Longevity Annuity Contracts (QLACs). A QLAC is a deferred income annuity that can only be purchased with assets from a retirement account.
  • Marry someone younger! Yes, you read that right! Your spouse's age determines how much RMDs you need to take every year. If your spouse is 10 years younger or you are not married, then the IRS allows you to withdraw a smaller amount each year which means you’ll pay lower taxes.

What Can You Do With Your RMD?

After you withdraw your RMDs and pay taxes on them, you can use them like any other income—to spend, save, or give away. For example, if you don’t need the money to cover your living expenses, you can invest it in a taxable account for future needs or legacy.

Taking RMDs can be complex, and it’s a good idea to consult a wealth advisor to develop strategies that minimize your taxes and support your retirement goals. In addition, if a version of the proposed SECURE Act 2.0 passes, your wealth advisor can help you make sense of how it may impact you.

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