The federal government loves its acronyms — EPA, FBI, CIA, IRS. But for retirees, among the most important acronyms to understand is this: RMD.
RMD stands for required minimum distribution, three seemingly simple words that are fraught with financial implications. What is their significance? Simply this: Once you reach a certain age, the IRS will require that you begin withdrawals from your tax-deferred retirement accounts, such as traditional IRAs or 401(k)s . You will have to make those withdrawals annually even if you keep working, don’t need the money and even if the markets are down and you prefer to wait for a recovery to regain losses. Failure to take your RMD will result in a stiff excise tax penalty.
The reason for these forced withdrawals? Very simple. You haven’t paid ordinary income tax on these accounts — and Uncle Sam is tired of waiting around. For years, even decades in many cases, you’ve been allowed to defer the tax on these accounts, resulting in compounding interest. That was advantageous for you, but at the same time that you were constructing a nice nest egg for retirement, you were also building up an IOU to the IRS . After all, the tax bill on that money was deferred, not eliminated. Once you retire, any money you withdraw from these accounts is taxed at current ordinary income tax rates.
Once you are of RMD age, you are required to take annual distributions. Failure to complete your mandated annual distribution will result in a 25% excise tax penalty. And all this time, you thought these accounts belonged 100% to you. You forgot that you have a “silent partner” in these accounts with you. Although, your “silent partner” doesn’t remain silent forever.
Like it or not, if any of your retirement savings are in a tax-deferred account, then the RMD will affect you at some point. That’s why it’s important to understand RMDs, how they work, what to expect from them and what you can do to soften the blow to your wallet.
Three key pieces of information you should be aware of are:
1. The age when your RMDs begin to apply.
The magic age for RMDs is fully dependent on when you were born. The RMD age is 70½ for those born before July 1, 1949; 72 for those born between July 2, 1949, and Dec. 31, 1950; 73 for those born between Jan. 1, 1951, and Dec. 31, 1959; and 75 for those born on or after Jan. 1, 1960.
Understanding and being prepared for when you are required to begin your RMDs is a crucial component of a successful retirement. Unfortunately, many are caught off guard and, consequently, suffer large and unnecessary tax burdens.
2. The withdrawal percentage rises with each passing year.
Many people, even when they know about RMDs, are surprised to learn that the percentage amount you must withdraw is not static. It increases each year through age 90.
Just a few examples: At age 72, the withdrawal percentage is 3.65%; at age 75, it is 4.07%; at age 80, it is 5.16%; and at age 90, it is 8.77%. This becomes especially frustrating when you are watching the balance in the account go down while the percentage you must withdraw increases each year.
3. Lack of an RMD strategy could prove costly.
As with nearly everything in retirement, it’s important to have a plan for your RMDs. We see many folks who take their RMDs and don’t need the income . So, in their attempt to be savvy, they reinvest the net proceeds into a taxable vehicle to continue on the path of growth.
The problem with this? As that money grows inside of that taxable vehicle, it is taxed again at capital gains tax rates, thus unknowingly giving Uncle Sam a second bite. This is where it comes in handy to have a tax-efficient financial professional in your corner who understands tax planning and can help you come up with strong solutions.
What are strategies you can use to help limit the amount you pay Uncle Sam?
One unique strategy is to break up the IRA into two IRAs, with IRA No. 1 invested in the market and IRA No. 2 kept out of the market. This way, if the market is down, you can withdraw the full RMD amount from IRA No. 2. If the market is doing well, you can withdraw the RMD from IRA No. 1.
Another strategy is to consider a Roth conversion . This can be a more sophisticated strategy, so be sure that your adviser is knowledgeable and experienced in helping their clients complete this. The idea here is to break off a specific amount of your IRA and convert or reposition that amount to a Roth IRA . Be advised that whatever amount that you do convert will be subject to your specific ordinary income tax rates, for that calendar year. For many, this can be an effective long-term strategy.
Ideally, you don’t want to wait until you are already in retirement before you start planning how you will handle the RMDs — and the other aspects of your retirement. It’s a good idea to seek guidance from a financial professional, so you get everything organized well in advance.
It’s about planning and being proactive, not being reactive.
Ronnie Blair contributed to this article.
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