The biggest benefit of retirement accounts like IRAs and 401(k)s is not having to pay tax on your earnings until you withdraw money from your account. But most people who were 70 or older before June 30 of this year have to start taking money out of their IRAs. Not taking your required minimum distribution, or RMD, in 2013 could cost you plenty.
Why you might have to take an RMD in 2013
The idea behind the required minimum distribution is that it puts a limit on your ability to defer taxes in your retirement account. When lawmakers created IRAs and 401(k)s, they knew many investors would never want to pay tax on that money, waiting until the last possible moment to take withdrawals. That's why the RMD rules force you to take withdrawals after a certain age, even if you don't need them.
RMD rules are a bit complicated, as they apply to those who are age 70 and a half or older by the end of the year. Most people are required to take their RMDs by Dec. 31 each year, but if you've just turned 70 and a half in the past year, you get a one-time break to wait until April 1 of 2014.
There's another group of people who have to take RMDs: those who have inherited an IRA. Usually, you have to take a required minimum distribution from an inherited IRA, regardless of your age.
How much you have to take out
Once you figure out that you're required to take a minimum distribution, the next step is to figure out how much you have to withdraw. The amount is based on two important numbers: the balance in your retirement account as of the end of last year and your life expectancy as provided by the IRS.
Life expectancy is based on age and changes from year to year, but the percentage of your total balance that you have to withdraw goes up every year. As this IRS table (link opens PDF) shows, those who just turned 70 have to take about $3.65 for every $100 they had in their retirement accounts at the end of 2012, while those who are 80 years old have to take about $5.35 for every $100.
What if you don't take your RMD in 2013?
If you miss the deadline for taking your RMD, the IRS imposes a harsh penalty: 50% of what you should have withdrawn. With the potential to lose half your money, you don't want to forget about taking your RMD before 2013 ends.
The biggest challenge about RMDs
For many, the biggest problem is generating enough income in their IRA or 401(k) to make a required minimum distribution. Yields on iShares Core Aggregate US Bond (NYSEMKT: AGG ) and other popular bond ETFs are less than 2.5% right now, leaving most conservative retirees well short of having the income they need. Even the 6% yields you can get from junk bond ETFs iShares iBoxx High-Yield Corporate (NYSEMKT: HYG ) or SPDR Barclays High Yield (NYSEMKT: JNK ) aren't enough for many retirement investors in their 80s.
One solution is to use the need for cash as a way to rebalance your portfolio. If you sell winning investments that have become a big enough part of your overall holdings that they're now riskier than you'd like, then that can generate the cash you need to make your RMD for 2013. Just bear in mind that because it takes three days for cash proceeds from selling stock to settle, you should act as soon as possible to get your RMD taken on time.
If you haven't taken your RMD for 2013 yet, don't wait any longer. Paying the IRS half your RMD amount would be the worst possible result for retirees, many of whom can't afford to give up any more money for taxes than they already have to.
Be smart about your taxes
Not paying half your RMD for 2013 in penalties is just one way you can help reduce your bill to Uncle Sam. In our brand-new special report "How You Can Fight Back Against Higher Taxes," The Motley Fool's tax experts run through what to watch out for in doing your tax planning this year. With its concrete advice on how to cut taxes for decades to come, you won't want to miss out. Click here to get your copy today -- it's absolutely free.