Saving for retirement is a lifelong pursuit, and using tax-favored accounts like IRAs and 401(k) plans is a great way to help set aside money for the future. Using traditional 401(k)s and IRAs usually comes with a built-in time limit, though, because you typically have to start taking required minimum distributions (RMDs) once you reach age 70 1/2. Fail to do so, and the IRS won't hesitate to charge one of its most onerous penalties: 50% of what you should have withdrawn under the RMD guidelines.
However, there's one big exception to the RMD rules, and it applies to those who are still working when they hit age 70 1/2. However, the exception doesn't apply to all of your RMDs, so it's important to understand the rule fully and plan accordingly if you want to take advantage of it.
The basics of RMDs
In general, the IRS makes you take out required minimum distributions from traditional IRAs and 401(k) plan accounts in the year in which you turn 70 1/2. You calculate the RMD amount by taking the value of your retirement accounts at the end of the previous year and then dividing it by a factor provided by the IRS. This factor is based on your remaining life expectancy given your age. Most retirees in their 70s end up having to take between 4% and 5% of their total retirement account balances as RMDs, while older retirees have to take proportionally more.
You typically have until Dec. 31 to withdraw the RMD amount from your retirement accounts to avoid penalties. In the year in which you reach age 70 1/2, you have a one-time extension that gives you until April 1 to take your RMD.
How late-workers can get an exception -- sometimes
However, there's an exception that allows some people not to have to take RMDs even once they turn 70 1/2. The key is that you still have to be working at that age in order to qualify.
The exception for those still working is consistent with the overall RMD concept. That makes sense intuitively. The idea behind forcing people to take RMDs in the first place was to help prevent people from delaying taking their money even after they retired just to reap the tax benefits longer. If you're still working, though, then forcing you to tap retirement assets doesn't really make sense.
It's crucial to understand, though, that this exception has a number of caveats:
- It only applies to 401(k) plans. If you have your retirement money in an IRA, then you're out of luck -- you still have to take RMDs even if you're still working.
- If only applies to the 401(k) plan at your current employer. If you have other 401(k) plans at previous employers, they'll still be subject to the RMD rules.
- Not all 401(k) plans offer the exception for workers. Your plan has to include specific language allowing the exception in order for you to use it.
In addition, you have to be careful with the exception even if you qualify. For instance, if you use the exception and work the first part of the year but then retire in the middle of the year, you still have to take an RMD for that year. That's true even if you leave work in December. You'll still have the extended April 1 deadline for the first year in which you have to take the RMD, but you can't avoid the penalty just by working a portion of a year.
Be smart with your RMDs
Required minimum distributions are a hassle, but the penalties for not taking them are so draconian that you can't afford any slip-ups. If you're still working, you might be able to avoid having to take RMDs from your current employer's 401(k) plan, but you should still check with your HR department to make sure the exception is available in your particular case.