Today, we are diving into RMD and why it is important.
Required Minimum Distributions are called RMDs for simplification. The most common RMD is from your retirement account. However, if you inherit someone else’s retirement account, you can also have a separate RMD for that account each year.
To clarify what an RMD is, think about your lump sum of money for retirement. Uncle Sam has patiently been waiting for you to start taking money from it once you retire.
Why? The government has never received any taxation on that pool of money. You get a tax deduction when you put the money in the account. It’s been growing for 10, 20, 30 years or more, and you need to pay tax on the money. Uncle Sam wants his “fair” share now that you are retired.
What is the taxation of my RMD?
You know the old saying, “pay the piper.” If you have any pretax retirement account, such as an IRA, SEP, or 401k, you must eventually pay Uncle Sam. One day you will have to pay the piper, meaning Uncle Sam will come to collect his share of your money.
It could be 0% taxation based on your low income and deductions for some. Others who have saved money have other income sources and few deductions. For example, some may have paid off their home and are no longer able to deduct their children, leaving them in the 25-30% federal tax rate.
Some of you will also be required to pay state taxes. This article deals with federal guidelines, as many states treat this differently.
All those years you have been putting money into retirement and getting a tax deduction, you were trading taxes now for taxes later. There is no free lunch. The bet you are making with Uncle Sam is that you will be in a lower tax bracket when you retire versus when you are getting your tax deduction from your earned taxable income.
That is how you win the game.
The truth is that some of you will be in a lower tax bracket in retirement, and some will not. You never know at age 25 or 30 how your retirement will turn out. For example, how much social security or income from your pension or profit-sharing plan will you receive or how much you might have saved? It is important to understand that because Roth IRAs are funded with after-tax dollars, the RMD rules do not apply to them.
How is RMD Calculated in 2023?
In 2023, your required minimum distribution (RMD) is calculated using the Uniform Lifetime Table. This table was created by the Internal Revenue Service (IRS) and provides a guideline for calculating RMDs from qualified retirement accounts such as traditional IRAs and 401(k) plans.
Your RMD is based on your life expectancy and the amounts in your qualified retirement accounts. The RMD amount is calculated with a table that provides life expectancy factors.
To calculate your 2023 RMD, you must first add up the balances of all of your qualified retirement accounts as of December 31, 2022. Then, divide that number by your life expectancy factor from the table. The resulting number is your RMD for 2023.
For example, if you are age 75 in 2023 and have a total of $500,000 in qualified retirement accounts as of December 31, 2022, then your RMD would be calculated as follows:
You would need to withdraw this amount from your retirement accounts in 2023 to satisfy your RMD requirement.
It’s important to remember that you must take your entire RMD by December 31 of the given year, or you may be subject to a penalty.
If you need help calculating your RMD, please consult a qualified financial advisor or tax professional. They can provide personalized guidance and help you meet all your required minimum distribution requirements.
What are the Required Minimum Distribution (RMD) Rules?
To better understand what is required minimum distribution, you must understand the ever-changing rules. For example, the required age to take RMD was originally 70 1/2, then it changed to when you turned 72, and now in 2023, the new age is when you turn age 73. Whether you need the money or not, you must take a certain calculated minimum amount of funds from your pretax retirement plans and pay taxes on it.
A uniform lifetime table is calculated against the account balance of the account on December 31 of the previous year. It’s approximately 4% of the value, and the amount continues to grow each year as you age. This starting age will shift to age 75 in 2033.
The guidelines say you have until April 1 of the following year to take that first RMD. You will also have to take two RMDs that year if you wait.
For example, if your account is worth $1,000,000. That first year you would need to take out at least $36,496 and pay taxes on that money. However, the tax rate will depend on your other taxable income and deductions.
So if you delay taking that distribution the first year until the following April 1, you will need to take out that $36,496 + the next year of similar amounts so that we could be talking about $80,000 in just that one year. That amount could push you into a higher tax bracket. Worse, it could also impact your Medicare premiums.
Creating a plan will help you make the best choices, not just for one year but years in advance. You can also see how that might impact your tax bracket, especially if you are single.
If you need support managing your money or making the best financial choices, start here:
Should I wait to take my Required Minimum Distribution?
Why would you wait? Maybe you are still working and earning taxable income. You may have another source of taxable income that year that will go away or decrease.
There are several good reasons, but some tax planning is in order so that you don’t double up and end up in a higher tax bracket just because you waited. As of 2023, if you decide not to take an RMD or skip one, the tax penalty is 25% of the amount you should have taken. You want to have a good reason for not taking it.
Suppose you have multiple different IRA/401k types of accounts. In that case, you must either take the minimum from each account based on its sole valuation from December 31, OR you can take the total of all RMDs calculated from one account. You can mix and match as needed to make sure that no matter what, you take out that total RMD in that year.
Insight on Inherited IRAs and RMDs
To further address inherited IRAs and RMDs, you should know that unless you are the spouse, you will have a short window to start and complete withdrawals from the account.
Spouses can transfer the IRA to their name and draw on the funds as if it were their own and their timeline. Non-spouse heirs after 2020 are subject to a maximum 10-year withdrawal timeline.
That means you can draw some out each year, draw some out once in a while, or wait and draw it all out by the end of the 10th year. While spouses can make withdrawals over their lifetime, non-spouses must draw out every penny by the end of the 10th year or face penalties. The key here is that Uncle Sam wants his tax money sooner rather than later, and since you did not save this money for your retirement but merely inherited it, the timeline has been drastically shortened.
Factors to Consider
The reasons for choosing every year vs. waiting until the 10th year can vary for different reasons. Someone working now but might retire in 3 years can wait until they retire, then finish drawing out the money at a lower tax bracket through the 10th year. Someone younger may benefit more by making modest withdrawals each year to spread the tax burden as much as possible.
Requirement Minimum Distribution Loopholes
Everyone loves a good exception. If you are a full-time employee with less than 5% ownership in the company, you can avoid distributions from a 401k. Once you retire, then you must begin normal RMDs if you are 73 or older.
If you have a ROTH IRA or ROTH 401k, there are no longer any RMD requirements. However, non-spousal heirs are subject to the 10-year rule. There is no taxation on the ROTH. Therefore, there is little incentive to withdraw funds from an inherited ROTH until the final year so that all the money can continue to grow tax-free.
Conclusion – What is Required Minimum Distribution
There are many factors to consider before you take your RMD (required minimum distribution). Factors to consider include your current need for money, your spouse or ex-spouse’s benefit, and how long you were married.
The best first step is to create a financial plan. In addition, you want to make a spending plan that includes a cash flow analysis. This will give you a big-picture view of your situation and options and increase your odds of a financially stable retirement.