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If you have savings in a tax-deferred retirement account such as a traditional IRA or 401(k), you're required to start taking minimum distributions after you turn 70-1/2 years old. Here's how to determine whether you've withdrawn enough yet and what you need to know about the RMD rules and penalties.
Required minimum distributions
Traditional IRAs, 401(k)s, and other tax-deferred retirement accounts have an excellent benefit -- pay no taxes on some of your income now, allow your investments to grow tax-deferred, and only pay income taxes when you withdraw the money.
One big caveat to this is that you can't simply let your money grow and avoid any tax liability forever. You generally must begin taking distributions from these accounts when you reach the age of 70-1/2, and these are known as required minimum distributions, or RMDs.
The exact amount of your RMD each year is calculated based on your age and the balance of your account at the end of the previous calendar year. The Internal Revenue Service provides life expectancy tables, and there are two to use -- one for most retirees known as the "Uniform Lifetime Table" and another if the account's sole beneficiary is a spouse more than 10 years younger than the account owner.
As an example, let's say that you had $800,000 in a 401(k) at the end of last year and you're 75 years old. Per the Uniform Lifetime Table, your expected distribution period is 22.9 years, so to figure out your RMD, divide your account's balance at the end of the year by this factor, which translates to an RMD of $34,934.
You can take your RMD as a lump sum, or in several payments, as long as you take out the required amount by the deadline, which is generally Dec. 31 (more on that in the next section). For example, if you're required to take an RMD of $50,000 in 2017, you can choose to take $4,167 per month, $961 per week, or just take it in different amounts as you need the money.
Finally, if you have more than one account with an RMD requirement, you'll need to calculate the RMD requirements for each account individually, but you can choose to take them from just one account, if you desire to do so.
You have extra time for your first one, but...
As the IRS rule states, your first required minimum distribution must be taken by April 1 of the calendar year following the year in which you turn 70-1/2. In other words, if you are going to turn 70-1/2 anytime in 2017, your first RMD doesn't need to be taken until April 1, 2018.
However, subsequent RMDs must be taken by Dec. 31 of each year. So, if you wait until the last minute to take your first RMD, you'll have to take your first two RMDs during the same calendar year.
This can have massive tax consequences. For example, let's say that you're retired and filing a single tax return. If you have a $1 million IRA, your first RMD at age 70-1/2 would be $36,496 according to the Uniform Lifetime Table and your second would be $37,736. The combination of these would push you well into the 25% tax bracket, without including any other taxable income, while taking just the first before the end of the calendar year in which you turn 70-1/2 would translate to a marginal tax rate of just 15%.
Therefore, be sure you're fully aware of and prepared for the tax consequences before taking your first two RMDs during the same calendar year.
What if you don't take an RMD this year?
Why am I spending so much time talking about RMDs? Simply put, the penalties for not taking a required minimum distribution are some of the most severe penalties the IRS can assess.
Failing to take a required minimum distribution can result in a 50% excise tax on any amount that was supposed to be distributed but was not. In other words, if you were required to take $50,000 from your traditional IRA this year but only take $20,000, you can be penalized 50% of the difference, or $30,000.
Because of this severe penalty, it is extremely important for you as a retiree to know exactly how much you need to take from your retirement accounts each year, and make sure to do it in a timely manner.
