The whole purpose of saving for retirement is to have money to tap once your career comes to an end. So for some savers, the idea of being forced to take distributions from an IRA or 401(k) isn’t so problematic, since that was the plan from the start.
But required minimum distributions, or RMDs, can be a problem in some situations. It’s important to know how RMDs work, which retirement plans they apply to, and how to avoid them.
What are RMDs?
An RMD is a withdrawal you must take from a tax-advantaged retirement plan at a certain age. RMDs are calculated based on your savings balance and life expectancy tables. As such, they’re not set in stone, but rather, can change from one year to the next.
When do RMDs start?
The rules of RMDs have evolved over time. It used to be that they began at age 70 ½, but then they were pushed back to 72.
However, starting this year, RMDs don’t begin until age 73. And beginning in 2033, they won’t kick in until age 75.
What this means is that many retirees do not have to take RMDs right away. If you wrap up your career at age 67 this year, you won’t have to start tapping your retirement savings for another six years if you don’t want to.
Why are RMDs a problem?
For some seniors, they aren’t. Many people need to live off their savings once their careers come to an end.
Remember, Social Security benefits generally only replace about 40% of a typical earner’s pre-retirement wages. Most seniors don’t want an instant 60% pay cut, so they commonly turn to their savings for extra income.
However, not everyone needs to tap their retirement plan at age 73. Perhaps you retired at 67 but maintained a side business that’s been generating enough income for you to live on. If you’re forced to take an RMD, that withdrawal counts as income — taxable income. And it’s frustrating to pay taxes on money you don’t actually want or need.
But while a tax bill for an RMD can be costly, it can be even more expensive to not take an RMD when you’re supposed to. Failing to take an RMD could leave you on the hook for a 25% penalty. So if you’re supposed to take an RMD of $10,000 and you don’t remove that money from your retirement account, you could lose $2,500 off the bat.
It’s worth noting that the penalty for failing to take RMDs used to be 50%, so 25% is a less harsh blow. But it’s one you’ll probably want to avoid.
That said, in some cases, you might only face a 10% penalty for failing to take an RMD. If you take a missed RMD by the end of the second year after the year it was initially due, you can whittle your penalty down to 10%. So if you don’t take your 2023 RMD on time but take it before the end of 2025, you might end up with that lower penalty.
Still, a 10% penalty isn’t exactly great. That’s the same penalty you’ll face by tapping an IRA or 401(k) plan prior to age 59 ½. So it’s generally best to take your RMDs when you’re supposed to.
How to avoid RMDs
If you don’t like the idea of being forced to take money out of your retirement savings, then you may want to house your nest egg in a Roth IRA or Roth 401(k). Roth IRAs don’t impose RMDs now. And starting next year, neither will Roth 401(k)s.
But traditional IRAs and 401(k)s do impose RMDs. So if you’re saving in one of these accounts, know that you’ll eventually be forced to remove that money.
And if you’re wondering why that’s the case, it’s because the IRS does not want these tax-advantaged retirement accounts to serve as a means of passing on generational wealth. Remember, the money you have in a traditional IRA or 401(k) gets to continue benefiting from tax-advantaged growth while you’re in retirement. The IRS is only willing to let you do that for so long.
Now to be fair, with a Roth IRA or Roth 401(k), you’re also getting tax-free gains in your account during retirement. The difference is that you didn’t get a tax break on your contributions, whereas with a traditional IRA or 401(k), you did.
All told, RMDs are important to keep track of so you don’t end up losing a portion of your hard-earned savings to IRS penalties. If you’d rather set yourself up to avoid RMDs altogether, consider housing your savings in a Roth IRA or Roth 401(k) to begin with.
