Editor's note: A previous version of this article stated an incorrect age at which required minimum distributions are necessary. The author and The Motley Fool regret the error.
There's a benefit to saving for retirement in a traditional IRA or 401(k) plan. The money you contribute, up to the allowable limits set by the IRS, can serve the very important purpose of exempting some of your income from taxes, all the while giving you access to funds you can use later in life.
But the problem with housing your nest egg in a traditional retirement plan is having to deal with required minimum distributions, or RMDs, down the line. RMDs are calculated each year based on your retirement plan balance and life expectancy. But in a nutshell, they force you to remove a portion of your traditional IRA or 401(k) balance each year or otherwise risk a penalty.
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Your first RMD is due by April 1 the year after you turn 73. From there, subsequent RMDs are due by December 31 each year.
Now for some people, RMDs aren't really a problem because they need to remove funds from their savings anyway to cover their bills. But let's say you're forced to take a $10,000 RMD when you don't need the money. Well, you just created a $10,000 tax liability for yourself -- meaning, the IRS gets to tax that $10,000 as income.
But that's not the only pitfall you might encounter if your retirement plan requires RMDs. Here are two other issues that could arise.
1. RMDs might cause your Social Security benefits to be taxed
If Social Security is your only source of retirement income, then you may not be taxed on your benefits. But if you're single and your combined or provisional income -- which is 50% of your annual Social Security benefit plus your adjusted gross income and non-taxable interest income -- exceeds $25,000 , you'll face taxes on your Social Security benefits. The same holds true if you're married and your combined income exceeds $32,000.
Now, let's say you're single with a $32,000 annual Social Security benefit. Half of that is $16,000, which is below the $25,000 threshold at which taxes on Social Security apply. However, if you're forced to take a $10,000 RMD, your provisional or combined income is bumped up to $26,000. That puts you in the category where you face taxes on your Social Security benefits.
2. RMDs might drive up the cost of your Medicare premiums
There's a standard monthly premium for Medicare Part B that currently sits at $174.70 per month. That standard premium can change from year to year.
But if you're a higher earner, you could face a surcharge on your Part B premiums known as an income-related monthly adjustment amount, or IRMAA. IRMAAs are based on income from two years prior. But if an RMD bumps up your income, then you pay end up paying a lot more for Part B.
Worse yet, IRMAAs apply to Part D drug plans, too. Now with Part D, there's no standard monthly premium like there is for Part B, since costs vary by plan. But you risk a surcharge as a higher earner, and an RMD might cause you to become one.
How to avoid RMDs
RMDs have the potential to be a huge financial pain. So if you're eager to avoid them, the solution is to save for retirement outside of a traditional retirement plan and instead choose a Roth IRA or Roth 401(k).
Roth 401(k)s used to impose RMDs, but that rule no longer exists. And unlike Roth IRAs, there are no income limits associated with Roth 401(k)s, making them a great choice for savers whose employer plan offers that option.
Meanwhile, if you're already in retirement and have stuck with a traditional savings plan, make sure to read up on the different ways RMDs might impact your finances. You may also want to sit down with an accountant or financial advisor to discuss strategies to minimize the negative hit RMDs might result in for you.
