The day you retire is a major milestone, and it's critical to make sure you're as prepared as possible before you start the next chapter of your life.
If you're planning on retiring in 2021, you likely have a checklist of things to do before you leave your job for good. You may want to double-check that your portfolio will be able to provide you with the income you'll need from it, for example. You might be getting ready to claim Social Security benefits. But there's one aspect of retirement finances you might be forgetting, and it could be a costly oversight.
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Accounting for withdrawals in your retirement plan
When you're thinking about how much you should withdraw each year from your retirement accounts, you may only be thinking about how much you'll require in order to cover your expenses. But for some accounts, you will be required to withdraw a certain amount each year, whether you need the money or not. If you don't pull out enough funds, you could face hefty penalties.
Once you turn 72, you'll need to begin taking required minimum distributions (RMDs). RMDs apply only to tax-deferred accounts, such as 401(k)s and Traditional IRAs, because you don't pay taxes on those savings until you start making withdrawals. The IRS wants its share eventually, so that's why you're required to begin taking distributions at a certain age.
If you don't take your RMD, you'll be hit with an IRS penalty of 50% of the amount you were supposed to withdraw.
The median amount that baby boomers have saved for retirement is $152,000, according to a survey from the Transamerica Center for Retirement Studies. But some workers have substantially more socked away, and the higher your account balances, the larger your RMDs will be. A few months ago, Charles Schwab surveyed 2,000 Americans ages 55 to 75 who had at least $100,000 in investable assets, and the average amount they had socked away was $920,400.
So, hypothetically, say you have $920,400 saved in a 401(k), and you'll be turning 72 in 2021. According to the IRS's RMD guidelines, you'll be required to withdraw $33,591 next year. If you don't withdraw anything from your retirement account, you'll face a penalty of close to $17,000.
How to avoid RMD penalties
The easiest way to avoid these penalties is to make sure you know when you'll have to take RMDs, and understand how much you should be withdrawing.
RMDs were waived in 2020 under the CARES Act, but seniors will be responsible for them again in 2021. If you're still working at age 72, you may be able to avoid taking an RMD from a 401(k) that's tied to your current employer. However, you'll still need to take them from your Traditional IRA or any 401(k)s from previous employers.
In addition, if you have multiple types of tax-deferred accounts, you will need to take RMDs from each of them. So, for example, if you have both a 401(k) and a Traditional IRA, you'll need to take cash out of each of them every year.
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Once you turn 72, you'll have until April 1 of the following year to take your first RMD. Then for each subsequent year, you must take your RMD by Dec. 31.
It's important to plan the timing of your initial RMDs carefully, because otherwise, you could end up taking two in one year. If you turn 72 in 2024, for example, you'll have to take your first RMD by April 1, 2025. Then your second would be required by Dec. 31, 2025. Withdrawing that much money from your tax-deferred accounts in one calendar year could potentially push you into a higher tax bracket, so you'd be better served to take your first RMD in the year you actually turn 72.
RMDs can be complex and confusing, as the specific fraction of your account balances that you need to withdraw will change every year. But by figuring out how much they'll be, and taking your RMDs on time, you can avoid penalties and help your nest egg go further in retirement.
