Required Minimum Distributions (RMDs) Explained Simply
If you have spent decades saving for retirement in a Traditional IRA, 401(k), 403(b), or another tax-deferred retirement account, there eventually comes a point when the IRS requires you to begin taking money out.
These mandatory withdrawals are called Required Minimum Distributions, or RMDs.
RMDs are an important part of Retirement Planning because they can affect your taxable income, Medicare premiums, charitable giving strategy, investment portfolio, and the amount of wealth you ultimately leave to your family.
At Dunnigan Financial Group, we believe retirement rules do not need to feel overly complicated. Here is a simple explanation of how RMDs work and why planning for them before they begin can be an important part of your overall financial plan.
What Is a Required Minimum Distribution (RMD)?
A Required Minimum Distribution is the minimum amount the IRS generally requires you to withdraw each year from certain tax-deferred retirement accounts once you reach the applicable RMD age.
For many retirees today, RMDs generally begin at age 73.
Why does the IRS require these withdrawals?
Contributions to many retirement accounts may have been made on a pre-tax or tax-deductible basis, and investment earnings have generally been allowed to grow tax-deferred. RMD rules eventually require a portion of those tax-deferred assets to be distributed.
Those distributions are generally included in your taxable income, although exceptions can apply when an account contains after-tax basis.
Which Retirement Accounts Are Subject to RMDs?
RMD rules generally apply to accounts such as:
- Traditional IRAs
- SEP IRAs
- SIMPLE IRAs
- 401(k) plans
- 403(b) plans
- 457(b) plans
- Other qualified defined-contribution retirement plans
One important exception involves Roth accounts.
Roth IRAs generally do not have RMDs during the original owner's lifetime. Under current law, designated Roth accounts within 401(k) and 403(b) plans are also generally exempt from lifetime RMDs for the original account owner.
Different rules can apply after the account owner's death, so beneficiaries should carefully review the distribution requirements that apply to inherited retirement accounts.
When Do RMDs Begin?
Under current federal law, many retirement savers must begin RMDs at age 73.
However, your specific required beginning date can depend on your date of birth, account type, employment status, and other factors.
For workplace retirement plans, some individuals who continue working may be able to delay RMDs from their current employer's plan until retirement. This exception generally does not apply if the individual owns more than 5% of the business sponsoring the plan.
Traditional IRAs, SEP IRAs, and SIMPLE IRAs generally require RMDs based on age even if you are still working.
Because these rules can vary, RMD planning is an area where working with your Financial Advisor, CFP® professional, and tax professional can be particularly valuable.
How Is an RMD Calculated?
The basic RMD calculation is relatively straightforward:
Prior Year-End Retirement Account Balance ÷ IRS Life Expectancy Factor = RMD
For example, suppose you have a Traditional IRA worth $1,000,000 on December 31 of the previous year.
If the applicable IRS distribution factor were 26.5, your approximate RMD would be:
$1,000,000 ÷ 26.5 = $37,736
That means you would generally need to withdraw at least $37,736 for that year.
The applicable factor depends on IRS life expectancy tables and your individual circumstances. Because account balances and applicable factors change, your RMD should generally be recalculated each year.
You can also visit our Retirement Resource Center, which includes an RMD estimator and other retirement planning resources.
Do You Have to Spend Your RMD?
No.
This is one of the most common misconceptions surrounding Required Minimum Distributions.
The IRS requires you to withdraw the money from the applicable retirement account, but that does not necessarily mean you have to spend it.
If you do not need the distribution for living expenses, you may potentially move the after-tax proceeds into a taxable brokerage account, add them to your cash reserves, use them for charitable giving, give money to family members, or use the funds toward another financial goal.
This is where Investment Planning becomes especially important.
An RMD should not necessarily be viewed as an isolated transaction. It can be considered as one component of your overall investment, income, and retirement strategy.
Are RMDs Taxable?
Generally, distributions from pre-tax retirement accounts are taxed as ordinary income.
For example, if you receive $60,000 from Social Security and other income sources and then take a $40,000 taxable RMD, that additional distribution may increase your taxable income for the year.
This is one reason RMDs and Tax Planning are closely connected.
Higher taxable income could potentially affect:
- Your federal income tax bracket
- The taxable portion of Social Security benefits
- Medicare income-related surcharges, commonly known as IRMAA
- Capital gains planning
- Charitable deduction strategies
- The taxation of other investment income
Rather than waiting until RMDs begin, it can be helpful to incorporate future distributions into your retirement income strategy years in advance.
Learn more about our approach to Tax Planning in Fort Collins and how tax considerations can be incorporated into a broader financial plan.
Why Tax Planning Before RMDs Begin Can Matter
Imagine retiring at age 65 but not being required to take RMDs until age 73.
Those years may create a valuable tax-planning window.
Depending on your financial circumstances, you and your advisors might evaluate strategies such as:
Roth Conversions: Converting portions of a Traditional IRA to a Roth IRA may create taxable income today while potentially reducing the amount remaining in accounts subject to future RMDs.
Strategic IRA Withdrawals: In certain situations, voluntarily withdrawing retirement assets before RMD age may make sense as part of a broader income and tax strategy.
Capital Gains Planning: Retirees with taxable investment accounts may coordinate gains and losses with retirement distributions.
Charitable Giving: Individuals with charitable goals may consider strategies designed to coordinate charitable contributions with retirement distributions.
None of these strategies is automatically appropriate simply because you are approaching RMD age. The appropriate approach depends on your income, tax situation, portfolio, retirement goals, estate plan, and other individual circumstances.
This is why Tax Planning, Investment Planning, and Retirement Planning should generally be viewed as interconnected pieces of the same financial picture.
What Is a Qualified Charitable Distribution?
A Qualified Charitable Distribution, commonly called a QCD, can be an important strategy for charitably inclined IRA owners.
A QCD allows an eligible IRA owner to make a qualifying distribution directly from an IRA to an eligible charitable organization. When the requirements are met, a QCD may count toward the individual's RMD while generally being excluded from taxable income.
For retirees who already intend to give to charity, this can be worth discussing with their financial and tax professionals.
QCD rules contain specific age, dollar-limit, account, and charitable-organization requirements, so distributions should be properly coordinated before they are made.
What Happens If You Miss an RMD?
Failing to take the appropriate RMD can result in an IRS excise tax on the amount that should have been distributed.
The rules provide opportunities for a reduced excise tax when certain errors are corrected within the applicable timeframe, but the best approach is to have a process in place to calculate and complete RMDs correctly and on time.
For retirees with multiple retirement accounts, keeping track of these requirements can become more complicated, particularly because aggregation rules differ depending on the types of accounts involved.
Should You Take Your RMD Early or Late in the Year?
There is no single answer that works for everyone.
Some retirees prefer taking monthly distributions to create a consistent retirement paycheck. Others take quarterly distributions, while some take their RMD in one lump sum.
The timing can depend on factors including:
- Cash-flow needs
- Market conditions
- Portfolio allocation
- Tax withholding
- Charitable giving
- Other income received during the year
From an Investment Planning perspective, it can also be helpful to determine which investments should be sold or distributed to satisfy an RMD rather than simply selling assets without considering your broader portfolio.
RMDs Are About More Than Taking Money Out of an IRA
Required Minimum Distributions may sound like a simple IRS requirement, but they can affect several areas of your financial life.
A thoughtful RMD strategy can involve coordinating your:
Retirement Planning — How much income do you need and where should that income come from?
Tax Planning — How could retirement distributions interact with your overall taxable income?
Investment Planning — Which assets should be used to fund distributions while maintaining an appropriate portfolio allocation?
Charitable Planning — Could a Qualified Charitable Distribution fit your charitable goals?
Estate Planning — How do your retirement accounts fit into the assets you eventually intend to leave to beneficiaries?
Looking at all of these areas together is one of the advantages of comprehensive financial planning.
Working With a CFP® Professional and Fiduciary Financial Advisor in Fort Collins
Retirement can involve much more than deciding when to stop working.
Social Security, pensions, retirement accounts, investments, taxes, Medicare, insurance, estate planning, and Required Minimum Distributions can all interact with one another.
At Dunnigan Financial Group, our CERTIFIED FINANCIAL PLANNER™ professionals work with individuals and families in Fort Collins, Colorado and beyond to bring these pieces together into a comprehensive financial plan.
As fiduciary financial advisors, our goal is to provide advice based on each client's individual circumstances, objectives, and financial needs.
If you are approaching retirement or already retired, understanding your future RMDs can be an important part of developing a thoughtful retirement income strategy.
Learn more about our Retirement Planning services, Financial Planning approach, and Tax Planning services.
Planning for RMDs Before They Arrive
Required Minimum Distributions do not have to be viewed simply as a tax deadline.
They can instead be incorporated into a broader conversation about how you want to generate retirement income, manage your investments, approach taxes, support charitable causes, and eventually transfer wealth to the people and organizations you care about.
For individuals approaching retirement, evaluating RMDs before age 73 may provide more time to consider potential planning opportunities.
If you are looking for a Financial Advisor in Fort Collins, a CFP® professional, or a fiduciary in advisory relationships to help coordinate your Retirement Planning, Investment Planning, and Tax Planning, Dunnigan Financial Group is here to help you evaluate your options and develop a strategy based on your individual circumstances.
Learn more about Dunnigan Financial Group or contact our Fort Collins office to start a conversation.
Important Disclosures
This material is for general informational and educational purposes only and is not intended to provide individualized investment, tax, legal, or accounting advice. The information presented is based on current federal laws and regulations, which are subject to change.
Dunnigan Financial Group and its financial professionals do not provide tax or legal advice. Clients should consult with their qualified tax professional, CPA, or attorney regarding their individual circumstances.
Investing involves risk, including the possible loss of principal. No investment strategy can guarantee a profit or protect against loss. Past performance does not guarantee future results.
Examples included in this article are hypothetical and are provided for illustrative purposes only. They are not intended to represent the performance or tax consequences of any specific investment or financial strategy.
Before implementing a Roth conversion, Qualified Charitable Distribution, retirement distribution, or other tax-related strategy, investors should consider their individual circumstances and consult the appropriate financial, tax, and legal professionals.
Disclosures:
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.