Retirement accounts, like IRAs and 401(k)s, come with several advantages for investors. One of the most important is you can defer the taxes on your contributions. Instead of paying taxes on your income during the year in which you earn it, you can wait until you withdraw your savings in retirement to pay taxes, giving you more money to invest upfront.
But you can't wait forever to pay your tax bill. Eventually, the government wants its cut.
That's why it imposes required minimum distributions (RMDs) on traditional retirement accounts. Seniors must start withdrawing funds from their accounts and paying the taxes on those withdrawals the year in which they turn 73. Anyone inheriting an IRA may be subject to RMDs as well.
The penalties for not taking an RMD are quite stiff. You could owe a penalty of up to 25% of the amount you were supposed to withdraw. Plus, you'll have to make the withdrawal and pay the income taxes anyway.
If you don't follow the rules correctly, you could be facing quite a tax bill when the IRS catches up to you. And that's even if you tried your best to follow the rules.
Unfortunately, it's all too common to make a mistake. Here are three big ones that can trip up people subject to RMDs.
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1. Missing the deadline for your RMD
The annual deadline for required minimum distributions is Dec. 31. But if you're manually requesting a withdrawal from your financial services provider, you probably want to get a head start on things. Many providers are inundated with all sorts of requests at the end of the year, and delays aren't uncommon. It's your responsibility to ensure the funds are withdrawn before year-end.
If it's the first year you're subject to RMDs, you'll get three extra months to make your withdrawal. The first RMD isn't actually due until April 1 in the year after you turn 73. Waiting until the next year to take your first RMD may be a financial mistake, though. Your second RMD is still due by the end of the year too, so you'll face a much larger tax bill that year as a result of delaying.
If you inherited an IRA from someone subject to RMDs after Dec. 31, 2019 and you're not a spouse, minor child, or less than 10 years younger than the original owner, you'll also be subject to RMDs. The IRS waived the RMD requirements for inherited IRAs from 2020 through 2024, but they'll go into effect in 2025 with the same Dec. 31 deadline.
Even if you're just a day late, you'll owe a tax penalty. Correcting the mistake within two years can reduce the penalty from 25% to 10%, but it's best to avoid it entirely.
2. Only withdrawing funds from one type of account
Many retirees end up with multiple types of retirement accounts, like an old workplace retirement account and an IRA. It's important to note that RMDs apply to each type of account separately.
If you have some money in a 401(k) and some money in an IRA, you'll need to make withdrawals based on the balances at the end of the previous year for each account. You can't withdraw solely from your 401(k) and cover the amount you were supposed to withdraw from your IRA as well.
Additionally, if you inherited an IRA, you'll need to make a separate RMD from the inherited IRA and your own IRA. And if you've inherited multiple IRAs from multiple people, you'll need to treat each one separately.
You can, however, combine your personal IRAs or 403(b)s (but no other types of accounts). If you have an IRA, a SEP IRA, or any other type of IRA, you can make a withdrawal from just one of the accounts to cover all of them. And it's also the same if you have multiple 403(b) accounts.
Making a mistake here is particularly costly because you often can't put money back into your retirement accounts. So you'll have to pay the penalty, withdraw the correct amount, and forego the tax-free compounding for the money you withdrew from your other account by mistake.
3. Combining RMDs with your spouse
You might combine finances with your spouse and the IRS might even tax your joint income, but when it comes to RMDs, you can't combine yours and your spouse's.
You can't jointly own a retirement account with a spouse. Therefore, each spouse is subject to their own RMD, based on their age and the account balance in their own accounts at the end of the previous year. You can't withdraw enough from your own retirement accounts to cover the amount your spouse would have to withdraw from theirs, or vice versa.
This is another mistake that comes with significant costs. You or your spouse will have to correct the under-distribution and pay the penalty. Meanwhile, the other person won't be able to return the funds they withdrew to the tax-advantaged account.
Knowing the rules can help prevent these mistakes, but if you have any uncertainty, it may be best to consult with a financial advisor. A short consult with a fee-only advisor should provide enough information to keep you out of the IRS's penalty box.
