You may have until April 17 to figure out contributions to retirement plans, but don’t confuse it with the deadline for mandated withdrawals known as required minimum distributions (RMDs). That ship has already sailed for the 2017 tax year and if you are late or miscalculate how much you owe, you get hit with a 50% penalty on the owed amount.
Let’s back up: The money you put into a 401(k), 403(b) or other defined contribution retirement plan is not tax exempt. It’s tax deferred.
Your time to pay up comes when you take RMDs — annual withdrawals from your IRA that are taxed as income, not capital gains.
RMDs Are Annual
RMDs aren’t a one-off type of tax. They happen annually, once you turn 70.5 years old — or if you inherit an IRA and do not intend to liquidate it within five years.
Fortunately, RMDs don’t kick in on a Roth IRA during the lifetime of the original accountholder — but after a person’s death, the beneficiary who inherits the Roth would have to start taking distributions.
And no, the estate tax exemption doesn’t apply to IRAs because, again, these are tax-deferred — even though the heir isn’t the one who did the deferring, someone still gets to pay the postponed taxes.
Timing of Distributions
The first year you take the distribution, you have a bit more time to do it than in subsequent years. The deadline is April 1 following the year you turn 70.5 or inherit the IRA.
Heirs have some additional wiggle room, since they effectively have five years to decide whether to liquidate the whole IRA or change it to a beneficiary IRA.
Liquidating an entire IRA puts you into a whole new income tax bracket for the year, which usually makes annual RMDs look like a better choice by comparison.
Wait and You Pay More
Heirs who choose to wait a year or more before taking their first RMD you still have to make up for the previous year(s)’ distributions by taking care of them all with the first distribution.
Thereafter, heirs and retirees take the distribution by the end of the respective tax year, December 31`. Unfortunately, the RMD amount isn’t a static figure every year — it involves similar math to what insurance companies do.
Fortunately, you don’t need to be an actuary to get the math done — just use one of the free online calculators available on these websites:
Ask Your Financial Institution
Or if you don’t feel like messing with a calculator, you might be able to get the issuer of your IRA or your financial advisor to do the math for you every year.
Vanguard, Fidelity and other fund families offer to calculate the correct amount and notify you about it. These free services also let you opt to have the annual RMD deposited into a bank account or another non-retirement account — and you may be able to set up income tax withholding on the transactions as well.
You can also choose to have the RMD distributed in multiple payments throughout the year if you want more of a payroll type of effect, which can help you budget better.
Understand the Math
Speaking of budgeting better, you can do exactly that when you develop an understanding of what RMD math involves.
It requires you to refer to the IRS or Social Security‘s estimates to determine your remaining life expectancy — grim as it may be to consider, take the figure you arrive at from either link above and divide it into your retirement account balance as of the end of the tax year in question.
If you have more than one retirement account, you have to take a distribution from each of them, following the same formula.
Which Accounts?
However, the IRS does allow you to aggregate accounts that are of the same type — like if you have two different 401(k)s — and then you can take the distribution from one or the other if you find it easier to do so.
Double check with your accountant or financial planner before you only take a distribution from one account, because apparently this is a common type of mistake that the IRS penalizes at the 50% rate.
However, one thing you can’t do is rollover the RMD money into another retirement account — although you can put it into a taxable investment account.
You Can Start Earlier
If you want to reduce the amount of income tax you have to pay on RMDs in retirement, you could try taking distributions once you reach age 59.5.
Although you’d still owe income tax, you wouldn’t owe the penalty fee that’s normally charged on early withdrawals. This would enable you to reduce the size of the tax burden later on.
Indeed, taking withdrawals from retirement plans involves more complexity than contributing to them in the first place — but it’s worth it when you consider that your pre-tax money appreciated in value for around four decades, give or take.
And while people who inherit IRAs might find RMDs frustrating, there’s a lesson here: If you want to leave a legacy for heirs, IRAs aren’t the ideal investment product for that objective — they’re for funding retirement expenses that the ever-diminishing pool of Social Security funds can’t meet.
Readers, what issues concern you the most about planning for retirement?
Read More About Retirement Planning
If you liked this article, you just might love reading more from our abundant archive on the topic of retirement:
- 40 and No Retirement Account — Now What?
- Should You Really Postpone Your Retirement?
- Middle Class Adults Only Have $20,000 Saved for Retirement
- Early Retirement Without a Huge Nest Egg
- Reconsider Roth IRA Contributions Over the Next Decade
- 5 Things to Keep in Mind on National Employee Benefits Day
- How Mutual Fund Fees Impact Your Retirement
- Avoid Outliving Your Retirement Fund
- Should You Borrow Against 403(b), 401(k) or Other Retirement Plans?
Jackie Cohen is an award winning financial journalist turned turned financial advisor obsessed with climate change risk, data and business. Jackie holds a B.A. Degree from Macalester College and an M.A. in English from Claremont Graduate University.
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