Once you reach age 70 1/2, the IRS requires you to start taking distributions from your traditional IRAs. If you don't withdraw at least as much money as the agency demands, you'll be stuck with an enormous tax penalty. And the clock is ticking: Required minimum distributions (RMDs) for all but your first year must be made by Dec. 31.
How required minimum distributions work
RMDs are based on both your age and the balances in your tax-deferred retirement savings accounts (i.e., non-Roth accounts). The younger you are and the higher the balances in your accounts, the bigger your RMD will be for the year -- meaning that your first few RMDs are typically the largest.
To calculate your RMD, you use the IRS-provided worksheet that fits your particular situation. If your spouse is the sole beneficiary on your IRAs and is more than 10 years younger than you, you'll use the joint life RMD worksheet. Everyone else uses the uniform life RMD worksheet. The worksheet will walk you through the process of adding up the balances of your IRAs as of Dec. 31 on the previous year, looking up your life expectancy figure on the IRS-provided table, and dividing your IRA balances by your life expectancy to come up with your required minimum distribution total for the year.
Calculating RMDs: an example
Let's say you had $800,000 in your traditional IRAs at the end of last year and you're 72 years old. Assuming you qualify to use the uniform life method to figure out your RMD, you would look up your life expectancy in the "distribution period" column of the table at the bottom of the worksheet, which, for a 72-year-old, is 25.6 this year. Divide $800,000 by 25.6, and you get $31,250, which is your RMD for the year.
What if I miss my RMD?
If you don't take enough out of your traditional IRAs to meet or exceed your RMD for the year, you'll be forced to pay a tax penalty of 50% of the amount you fail to withdraw. In the previous example, the RMD was $31,250; if you only took $20,000 this year from your tax-deferred retirement accounts, you'd have missed your RMD by $11,250. As a result, you'd owe a tax penalty of 50% of that, which comes to $5,625. As you can see, failing to take your required minimum distribution is an expensive business.
Getting around your RMD
Required minimum distributions become an issue when the amount you're supposed to take is higher than the amount you actually need to take. This creates two different problems: first, you have to pay income taxes on the money you withdrew, which means you'll have an unnecessarily high tax bill at the end of the year; and second, taking extra money out of your IRA means that you're reducing your account's ability to produce income in future years by reducing its capital.
The simplest way to shrink down your RMDs is to put some of your retirement savings in a Roth IRA instead of a traditional IRA. Roth IRAs aren't subject to RMDs, and by reducing the balances in your traditional IRAs, you're reducing your RMDs as well.
Watch out for Roth conversions
If you didn't set up and fund a Roth IRA during your working years, you can still do so now by making a Roth conversion, which basically means moving money from your traditional IRA to a Roth IRA. However, there are a few things you need to consider before making a conversion.
First, you have to pay income taxes on the money you move into the Roth IRA for the year in which you move it. If you were to move your entire $800,000 balance from a traditional IRA into a Roth IRA, you would have a staggeringly high tax bill for the year. Second, RMDs are based on your balances from the end of the previous year. If you make a Roth conversion this year, it won't lower your RMD until next year.
If you have a large balance to convert to a Roth IRA, the best way to do it is to spread the conversion over several years. You won't be able to reduce or eliminate your RMDs as quickly, but you'll also spare yourself any massive tax bills. And even converting a small balance from your traditional IRA will reduce your RMD for the next year. It may not be the instant relief you were hoping for, but a Roth conversion achieved over several years can eventually get rid of your RMDs for good, giving you the freedom to withdraw only as much of your invested money as you see fit.