Remember when the Human Resources person dropped a stack of new employee forms in your inbox on your first day of work. The one named “401k – Contribution Enrollment” took some extra thought as you contemplated how much of your paycheck you could put away in exchange for delaying income taxes. Perhaps the company’s generous matching program enticed you to ratchet up your contribution amount as the allure of free money was too much to pass up.
Now, years or decades later, as you are edging closer to retirement, you’re feeling pretty good about what you’ve saved over the years. All those systematic contributions to your 401k, company matches, and compounded returns have added up! However, one important thing to remember is that all that money you think is yours, it really isn’t. You still owe the government its share for the taxes you’ve been deferring (unless you have a Roth 401k and already paid the taxes). And, at some point, the government wants its money. That point is when the RMD (Required Minimum Distribution) comes into play.
What is an RMD?
Irrespective of whether or not you need the money, the government requires you to start taking distributions from employer-sponsored retirement plans (i.e. 401k/403b) as well as other pre-tax retirements accounts (i.e. IRA’s, SEP IRAs, annuities, etc.) in the year in which you turn 70 ½.
These distributions, known as “Required Minimum Distributions (RMDs) or sometimes referred to as an MRD,” qualify as income in the year taken and are subject to income tax at the prevailing rates. Distributions can be taken either as a lump sum or installments. In addition, income taxes can also be withheld from the distributions.
If you are still working (and not a 5% or more owner of your employer’s company), you do not have to take an RMD from your 401k/403b until the year in which you retire. You are allowed to delay your first RMD until April 1st after the year you turn 70 ½ (or retire if you are over 70 ½ and still working). However, those electing to do so should be aware of the impact of taking two RMD’s in the same year on your taxable income as it might propel you into a higher income tax bracket, making it less advantageous to delay.
Here’s a couple of examples:
You are retired and your 70th birthday was June 30, 2013. You reached age 70½ on December 30, 2013. You must take your first RMD (for 2013) by April 1, 2014, but will have to take the second (for 2014) by December 31, 2014.
You are retired and your 70th birthday was July 1, 2013. You reached age 70½ on January 1, 2014. You do not have an RMD for 2013. You can take your first RMD (for 2014) by December 31, 2014 or wait until April 1, 2015. However, you would then need to take an RMD for both 2014 and 2015.
How is the RMD calculated?
A few variables factor into how much of a RMD you must take: your current age, the amount in your retirement account(s) as of December 31st of the prior year, and the distribution period taken from the IRS’s Uniform Lifetime Table (see Table III below). This table can be used unless the account owner’s sole beneficiary is their spouse who is more than 10 years younger.
To derive the RMD, take the prior year’s end-of-year balance and divide by the distribution period corresponding to the age you are turning in that year.
Let’s walk through an example of the calculation using the IRS schedule:
You are retired and turned 70 on August 31st of 2014. Since you did not turn 70 ½ until 2015, you could have delayed your first RMD until April 1st of 2016, and then taken your second RMD by December 31st of 2017. To calculate the amount of each RMD, assume your 401k balances were $325,000 on 12/31/15 and $435,000 on 12/31/16.
RMD for 2015(either taken by 12/31/15 or 4/1/16) = $325,000/27.4 = $11,861.31
RMD for 2016 (taken by 12/31/16) = $435,000/26.5 = $16,415
What Happens if you Don’t?
If you do not take an RMD or fail to take enough, the penalty can be significant. The IRS may assess a penalty equal to 50% of the amount not distributed so it is very important to be on top of these distributions. Of course, you can always request a penalty waiver if you have a good enough excuse.
SMS works with clients and their tax advisers to determine optimal strategies for taking distributions from retirement accounts, including RMD’s, as part of an overall retirement income plan. The goal is to minimize taxes while providing ample funds to meet retirement living expenditures.