Nothing lasts forever – and that includes the ability of the money in your IRA, 401(k), or similar employer-sponsored retirement plan to grow tax-deferred. Eventually, you will need to withdraw funds from these accounts. But the age at which these withdrawals must start changed beginning in 2020, and this change could affect your retirement planning.
Previously, you had to start taking withdrawals – technically called required minimum distributions (RMDs) – once you turned 70 ½. But in December 2019, Congress passed legislation, known as the SECURE Act, that raises the RMD age to 72. The SECURE Act also makes other changes to retirement accounts, which we will describe later.
There are stiff penalties for failing to take RMDs, so it is important to understand the rules for how RMDs work.
Why do RMDs exist?
RMDs exist because the federal government wants to make sure that you use the tax-deferred money that you set aside in your retirement accounts when you are actually in retirement. Without RMDs, people who had other sources of retirement income could simply leave their retirement assets untouched and allow the advantages of tax-deferred growth to continue compounding throughout the account owner’s life.
When do RMDs start?
Starting in the year that you turn age 72, you are required to take distributions of at least the IRS-mandated amount from your tax-advantaged retirement accounts. Even if you have already started taking distributions well before turning age 72, the RMD rules still apply.
For the first year that you are required to take a distribution, you have until April 1 of the following year to take the distribution. But after that first year, the deadline for taking the distribution is December 31 each year. For example, if you turn 72 on September 30, 2020, you would have until April 1, 2021 to take the distribution. But you would have to take your second RMD by December 31, 2021.
If the account owner dies before reaching age 72, then a different set of rules for RMDs applies to the account’s beneficiary.
What types of accounts do RMDs apply to?
The RMD rules generally apply to accounts where the government gave you some sort of up-front tax benefit to encourage you to save for retirement. This includes individual accounts such as IRAs, SEP IRAs, and SIMPLE IRAs, as well as employer-sponsored plans such as 401(k), 403(b), and 457(b) plans. The RMD rules, however, do not apply to Roth IRAs (more on that below).
If you have more than one of these accounts, the amount of your annual RMD will be based on the cumulative value of these accounts.
Why don’t RMDs apply to Roth IRAs?
It is important to note that RMDs do not apply to Roth IRAs. This is because the account owner does not receive an up-front tax deduction when making a Roth IRA contribution.
Because qualified contributions to a Roth IRA are not subject to RMD rules, the assets in the account can continue growing tax-free throughout the account owner’s life. This is one of the primary reasons why, under the right circumstances, Roth IRAs can be effective tools for transferring wealth to younger generations. Please contact us if you would like to learn more about how Roth IRAs work or the rules for converting a traditional IRA to a Roth IRA.
How are RMDs taxed?
Distributions from the accounts listed above, except for Roth IRAs, are generally taxed as ordinary income.
What are the penalties for not complying with RMDs?
There is a hefty penalty for not taking the full RMD amount or for not taking the distribution by the deadline. The difference between the amount that you were required to take as a distribution and the amount that you actually took is taxed at 50%. For example, if your RMD for 2019 was $1,000 but the distribution you took in 2019 was only $250, the $750 shortfall would be taxed at 50%.
How are RMDs calculated?
The RMD amount for a given year is determined by essentially taking a percentage of the account balance at the end of the previous year. The percentage of your remaining balance that you must withdraw increases as you age.
For more information about RMDs and how they are calculated, including the distribution period table for situations where the spouse is more than 10 years younger than the account owner, please visit the IRS’s “Retirement Plan FAQs Regarding Required Minimum Distributions.” (Be aware, though, that this material may not have been updated to reflect the new RMD age limit, which was passed into law in December 2019.)
How will the new RMD age affect me?
If you can afford to wait until you reach 72 to begin taking distributions from your retirement account, the extra year-and-a-half could affect you in at least two ways. First, it gives your retirement accounts additional time to grow tax-deferred—although, given the nature of the financial markets, this is no guarantee.
Perhaps just as importantly, though, if you were to wait until 72 to start taking RMDs, your withdrawals might be larger than if you had started taking them at 70 ½. And because RMDs are taxable income, this could affect your tax situation.
This potential problem, however, could be eliminated in the near future, because another proposed change may be on the way from the Treasury Department. Specifically, starting in 2021, the life expectancy tables used to calculate RMDs may be revised to take into account longer life expectancies. Using a longer life expectancy in the RMD calculation would result in lower amounts being taken out each year.
In addition to increasing the age at which RMDs must start, the legislation includes several other provisions, two of which may be of particular interest to you:
* No age limit for traditional IRA contributions – Before the new law, you weren’t allowed to make traditional IRA contributions once you reached age 70 ½. But under the SECURE Act, you can now fund your traditional IRA for as long as you have earned income. So, if you plan to work past what might be considered the typical retirement age, you will have the opportunity to add more money to your IRA.
* Loss of “Stretch IRA” provisions – Under the old rules, a non-spouse beneficiary would be able to stretch taxable RMDs from a retirement account over his or her lifetime. Now, the beneficiary will have to take all the RMDs by the end of the tenth year after the account owner passes away. Consequently, this change could have tax implications for family members who inherit your IRA or other retirement plan.
In addition, the SECURE Act contains changes that affect retirement plans for small businesses, so, if you are a business owner, you may want to look into the details.
What do RMDs mean for you?
The Retirement Network is committed to helping our clients navigate RMDs and other rules related to their retirement accounts. For our clients, we will contact you to let you know what your RMD amount is and to develop a strategy for generating the distributions. If you have any questions about RMDs and how they affect your retirement plans, we are always here to help.
 Proposed RMD Rules Would Trim Mandated Distributions for Retirees
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Please consult your financial advisor regarding your specific situation. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.