Saving for retirement in an IRA is one of the smartest moves you can make for your future. But managing that account in retirement is just as important.
Unfortunately, new data from TD Ameritrade reveals that Americans are sorely uninformed about a critical rule that applies to traditional IRAs: required minimum distributions, or RMDs. A good 62%, in fact, aren't aware that IRA withdrawals become mandatory at a certain age.
If you're saving in an IRA, it's crucial that you read up on RMDs. And if you're already retired, you must mark your calendar to avoid missing the deadline on taking them and suffering financially as a result.
How RMDs work
Saving in an IRA opens the door to a number of tax breaks. When you fund a traditional IRA, your money goes in tax-free, and gets to grow on a tax-deferred basis so that you're not paying taxes on your investment gains year after year.
There comes a point, however, where the IRS will no longer let you capitalize fully on those tax breaks. As such, you're required to start taking withdrawals from your account, known as RMDs, once you turn 70 1/2.
Calculating your RMDs can be a little tricky, though there are online tools that can help in this regard. If you work with a financial advisor, he or she can assist in coming up with that number, which will essentially be a function of your savings balance coupled with your life expectancy.
Your first RMD must be taken by April 1 of the year after the year you turn 70 1/2. That might sound complicated, but all it means is that if you turn 70 1/2 in 2019, your first RMD is due by April 1, 2020. All subsequent RMDs are then due by the end of their respective calendar years.
Now the problem with RMDs is that if you don't have a particular use or need for that money, withdrawing it will be a burden, as it'll trigger taxes for you. Remember, traditional IRA withdrawals are taxed as ordinary income, and if you have other income in retirement, your RMDs could propel you into an even higher tax bracket.
On the other hand, if you don't take your RMDs on time or in full, you'll suffer a pretty serious consequence -- a 50% tax penalty on whatever amount you fail to withdraw. This means that if your RMD for a given year is $10,000, and you take none of it, the IRS gets to keep $5,000 of your money. Ouch. Therefore, you should always make sure to take your full RMD, even if you don't need the cash. While you can't reinvest that money back into your IRA (or any other tax-advantaged retirement account, for that matter), you can invest it in a traditional brokerage account so that it keeps growing. The only thing you'll miss out on in that case is the tax-deferred growth we talked about earlier.
If you're still working and the idea of being subject to RMDs sounds unappealing, here's one solution: Save in a Roth IRA instead. Though Roth IRA contributions don't result in an immediate tax break, since they're made with after-tax dollars, you won't pay taxes on your withdrawals in retirement. You also won't be subject to RMDs, which means your money is free to sit and grow for as long as you'd like it to. You can even plan on leaving a portion or all of your Roth IRA to your heirs if you don't need it to pay your senior living expenses.
The only catch with Roth IRAs is that higher earners are barred from contributing to them directly. If that's the case, however, you can always fund a traditional IRA and convert it to a Roth after the fact.
Though RMDs can be a real drag, they're part of the territory when you have a traditional IRA. If you want to avoid them in retirement, house your savings in a Roth account. Otherwise, be prepared to consistently take withdrawals from savings once you reach a certain age, and accept the tax consequences involved.