After the Cares Act gave us a break from required minimum distributions (RMDs) in 2020, the normal rules are restored for 2021. We once again need to make sure that plans are in place for distributions from your retirement accounts if needed. In this post, we will discuss common questions about this requirement and how to plan ahead whether you are at RMD age or younger.
What are the rules?
Once you reach age 72, you are required to withdraw a certain minimum amount from your tax-qualified accounts each year. Tax-qualified accounts are accounts that you have contributed money to on a pre-tax basis and have tax-deferred growth. Examples of qualified accounts are your 401(K)s or other company retirement plans, traditional or rollover IRAs, or inherited IRAs. One key exception to RMD rules are Roth accounts. If you have a Roth IRA or Roth 401(k), this money is exempt from RMD rules.
Each qualified account will be counted to calculate your total RMD. To meet the requirement, withdrawals can be taken from just one account or spread across the applicable accounts.
The deadline for taking your withdrawal is April 1st in the year after you have turned 72 and then December 31st of each year after. It is really important to take your RMD before the deadline as the IRS will apply a severe penalty if the RMD is not taken. The penalty is 50% of the amount that is not taken.
For inherited accounts, the rules depend on your relationship to the deceased and can be a little bit more difficult to understand. For a reference to RMD rules for an inheritance, check out this page.
How is the RMD calculated?
The RMD value is determined based on a formula. The key values of the formula are:
1. The value of your account at the end of the previous year.
2. Your age
Here is how it works:
The image above shows an example of an RMD calculation. Some key items to consider are that the LE factor declines as you age. Remember that when you divide by a lower number, the value increases. This means that if your account value remains the same over time, you will be required to take more money out each year as you get older.
Example:
Age 72: $1,000,000/25.6 = $39,062.50
Age 80: $1,000,000/18.7 = $53,475.94
RMD options:
Since your retirement accounts are taxed as ordinary income, they are naturally a good account to withdraw money from for your retirement paycheck. If you are taking money from these accounts to live on or to supplement your income, you will most likely satisfy your RMD. However, sometimes you may find yourself in a situation where you don’t need the money from your RMD to pay your bills. Since you still need to take the withdrawal and pay the taxes, here are some options to consider:
Reinvest
You can schedule your RMD amount to be automatically paid to a non-qualified (non-retirement) investment account. A good option is to set up tax-withholding from your withdrawal and schedule an automatic transfer to the non-retirement account. This way the taxes will be paid, and the money can be re-invested for future needs. This is a great way to accumulate a nest egg of after-tax money that can be used for large expenses later in retirement.
Create a better inheritance
Tax-qualified retirement accounts can be some of the least effective ways to pass money to loved ones. This is because your heirs will need to withdraw the money and pay taxes on the money as income at their income tax rate. If passing money to your family is important to you, you may want to consider funding 529 college savings accounts with your RMD or converting some of your account to a Roth account. Keep in mind that a Roth conversion does not satisfy your RMD, but it may lower your future RMD requirement. Make sure to work with a professional (give us a call) when considering a Roth conversion.
Qualified Charitable Distributions
If you are charitable at heart, you may want to consider a qualified charitable distribution (QCD). A QCD is when you transfer money directly from your qualified retirement account to a charity. This money will count toward your RMD and will not be taxed! It is a great way to lower your taxable income, satisfy your RMD and take care of the charities that matter to you. There is a limit of $100,000 per year and this contribution does not count toward limits on deductions for charitable contributions. Also, you do not have to itemize your deductions in order for this donation to benefit you. Keep in mind, many churches and religious groups are qualified to receive charitable donations, so this can be a good planning tool if you normally pay a tithe.
Not 72? It’s time to plan ahead
If you have a while before you are required to take a retirement withdrawal, you can start planning now to optimize your future. Much of our planning for retirement is concerned with making sure a nest egg will last. My biggest concern with RMDs is that they force us to give up control over the amount that we withdraw in retirement. This is turn causes to lose control of our taxable income and expenses related to taxes.
If we have time to plan ahead, I recommend considering options to convert qualified accounts to Roth accounts. This may not apply to every situation; however, it is worth evaluating. With a Roth conversion, you move money from traditional retirement accounts to Roth accounts so that this money can grow tax-deferred and can be withdrawn tax-free. The key objective is to gain control over your future retirement withdrawals as this money will not be subject to a future RMD. The downside to a Roth conversion is that the converted amount is considered taxable income in the year of conversion. A Roth conversion is a decision to pay taxes now instead of later. It is important to consider your specific tax situation and work with financial professionals to create a strategy that is right for you.
Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.