Financial Planning

Understanding Required Minimum Distributions

What is a Required Minimum Distribution

A Required Minimum Distribution (RMD) is the IRS mandated money that must be withdrawn from tax-deferred accounts (SEP, SIMPLE, IRAs, and qualified plans) beginning at age 72 (or 70.5 if the account owner turned that age before Dec. 31, 2019).

RMDs act as a safeguard against individuals using retirement accounts to avoid paying taxes. The IRS allows savers to contribute money to specific retirement accounts, permitting decades of deferred taxes, but requires distributions at a time in the future. Once RMDs begin, they must be taken each subsequent year until the account has been completely liquidated, or at the individual’s death, whichever comes first.

Some qualified plans allow individuals to delay RMDs if the participant is still employed. In this instance, RMDs can be deferred until the worker retires. Employees who fall into this category should speak with their employers to determine if they are eligible for this deferral option.

Calculating Your Required Minimum Distributions

The IRS website provides information and worksheets to help investors calculate their RMDs. Fortunately, if you work with a financial institution, your planner will calculate your RMDs for you.

Understanding the Calculations

The IRS has multiple tables relevant to your specific scenario. Considering this, it’s important to ensure that you use the right table when calculating your RMDs. As an example, we’ll use Table III used by unmarried account owners, married owners whose spouses aren’t more than 10 years younger, or married owners whose spouses aren’t the sole beneficiary.

Table III for required minimum distributions

RMDs have three factors. Your age, the distribution period, and the account balance from Dec. 31 of the prior year. If you have these three values, the calculation is quite simple.

First, find your age on the table. As an example, we’ll assume I’m 73. Next, find the corresponding distribution age. If I’m 73, the corresponding distribution period is 24.7. Finally, determine the balance from December 31 of the prior year. I’m writing this post on Jan. 29, 2020. To determine my 2020 RMD, I would look at my account balance on Dec. 31, 2019. Let’s assume my IRA balance on Dec. 31 was $2 million. Here is how the calculation works:

How to calculate required minimum distributions

Additional Concepts to Understand

If you have more than one account that requires an RMD, you should calculate the RMD on each account separately. The distributions can come from each account or from one of the accounts. The account(s) the distributions come from are not important. Ensuring that the entire RMD value is distributed is what matters most.

If you are married, RMDs are calculated separately even if you are the same age. Each account owner is responsible for their own RMDs. If spouse one has a $50,000 RMD and spouse two has a $50,000 RMD, each spouse must distribute $50,000 from his or her account(s). The IRS does not allow either spouse to take a $100,000 distribution to cover both RMDs.

What Happens if You Don’t Take RMDs

If the account owner fails to make a distribution on time or for the right dollar amount, a penalty will apply with few exceptions. For every dollar not withdrawn, the IRS will impose a 50% penalty. If $25,000 of the RMD was not distributed, a $12,500 penalty will apply.

If you failed to distribute all or a portion of your RMD, the IRS can waive part or all of this penalty if you can show that any shortfall was due to reasonable error and you are taking reasonable steps to remedy the situation. Additional steps are required to request a waiver. You should speak to a tax professional to better understand the process and your options.

Final Thoughts

If you started investing at an early age, you reaped the benefits of tax-deferred growth for decades. But all good things must come to an end. If you are unfamiliar with RMDs, they can be complicated. For example, questions arise like: when do they start, how are they calculated, how often do RMDs need to be taken, and what happens if you don’t take them? My hope is, with the information provided in this post, all of those nuances have become clearer and make the RMD process less complicated for you.