Traditional retirement plans like IRAs and 401(k)s allow you to shield income legally from the IRS in the course of saving for retirement. That's why they tend to be a popular choice among long-term savers.
But there's a big drawback to saving for retirement in a traditional IRA or 401(k) plan. Not only do traditional retirement plans tax withdrawals, but they come with another big restriction you'll have to deal with starting at age 73 (or 75 if you were born in 1960 or later) -- RMDs.
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RMDs, or required minimum distributions, are withdrawals you're forced to take each year if you don't want to get hit with a big penalty. The reason behind RMDs is to ensure that IRA or 401(k) holders use their money for its intended purpose -- retirement savings, as opposed to passing wealth down from generation to generation.
RMDs are calculated annually based on your account balance and life expectancy. And they can be a huge pain if you weren't already planning to take money out of your retirement account.
That said, there are a few key mistakes you might risk making in the context of RMDs. Here are three to be aware of -- and try to avoid.
1. Taking RMDs when you don't have to
While you generally have to take RMDs starting at age 73, if you're still working at the time, you may qualify for an exception. If you're still employed, you do not have to take RMDs from your current workplace retirement plan provided you own less than 5% of the company.
However, this exception only applies to your current workplace plan. In other words, if you're still working and have money in your company 401(k), but you also have a separate IRA, the exemption wouldn't apply to the IRA. You'd still need to take that RMD on schedule to avoid a penalty.
2. Giving your RMD to charity the wrong way
If you don't need the money from your RMD, donating it to charity is a great way to do a nice thing and spare yourself an extra tax bill. But you have to go about things the right way.
If you do what's called a qualified charitable distribution, or QCD, you won't have to pay taxes on your RMD. But for your donation to count as a QCD, the money must go from your retirement account to a qualifying charity directly. If you withdraw the money from your IRA or 401(k) and then write a charity a separate check, it won't count as a QCD.
3. Forgetting you don't have to actually spend your RMD
One big misconception about RMDs is that you're not allowed to save or invest that money. It's true that you can't put your RMD back into another tax-advantaged retirement account, as that would defeat its purpose. You can, however, take your RMD and invest it in a taxable brokerage account.
And that's not your only option. You can put your RMD into a savings account or use it to fund a 529 plan for your grandkids' education.
If you don't need to spend your RMD, the IRS is not going to compel you to do so. So don't think of your RMD as wasted money.
Know the rules
It's important to understand how RMDs work if your retirement plan is subject to them. That said, if you don't want to deal with RMDs in retirement, plan to house your savings in a Roth IRA or 401(k).
Another option? Do a Roth conversion ahead of retirement.
Just be aware that a Roth conversion could result in a significant tax bill. You may want to work with a financial professional to move funds out of a traditional retirement plan strategically over time, as opposed to making your conversion a one-time thing. But if you're willing to deal with a tax headache ahead of retirement, it could spare you a world of financial stress during retirement.
