Simply accumulating a large sum of money in a retirement fund is not enough to guarantee a happy, healthy retirement. It is important to understand what required minimum distributions are and how they work, as well.
What are Required Minimum Distributions?
Required minimum distributions (RMDs) are sums of money that retirement plan participants must withdraw from certain retirement plans after they reach age 70 ½.
The purpose of RMDs is to prevent people from accumulating vast amounts of money in their retirement accounts, deferring taxation and leaving their funds as an inheritance to their beneficiaries.
Which Funds have RMDs?
Almost every type of retirement account is subject to RMDs, including:
- 401(k)s (Roth and Traditional)
- 403(b)s
- Profit Sharing plans
- Pensions
- Traditional IRAs
- SIMPLE IRAs
- SEP IRAs
All RMDs are subject to federal income tax. They may also be subject to state income tax, depending on state laws.
Roth IRAs
Roth IRAs do not require their owner to take RMDs while they’re alive. However, a Roth IRA passed down to a beneficiary will be subject to RMDs.
How to Calculate RMDs
Required minimum distributions from a given retirement account are calculated based on the account’s prior year-end fair market value, which is then divided by the applicable distribution period (or life expectancy factor, as determined by the IRS).
How are RMDs Taken?
Installments or Lump Sums
RMDs for a given year must be withdrawn by December 31 of that year. They can either be taken in a lump sum or in installments. However, someone who is taking an RMD for the first time may delay their withdrawals until April 1 of the following year after they turn age 70 ½.
Failure to take an RMD by the deadline may result in a 50 percent IRS excise tax on the shortfall.
RMDs for Multiple IRAs or 403(b)s
People with more than one IRA may calculate the RMD of each plan separately. However, if they have multiple IRAs, they may add the RMD amounts of all of the IRAs and withdraw the total from any one or more IRA. The same applies to 403(b)s.
RMDs for Multiple 401(k)s
Individuals with multiple 401(k)s are typically required to calculate and withdraw RMDs separately for each.
Why is it Important to Estimate RMDs?
Budgeting
By estimating one’s RMDs prior to retirement, it becomes clearer whether or not they must aim to accumulate more money in their retirement accounts to achieve the quality of life they desire.
Taxation
While building up their retirement accounts, many young workers forget that most of their withdrawals will be taxed. Understanding RMDs and their tax implications is an important piece of financial literacy.
Inheritance
For both executors and beneficiaries, estimating RMDs makes financial planning more successful.
Required minimum distributions are important to understand, because they provide more control over one’s financial legacy.
