You’re constantly being reminded to save for retirement in tax-advantaged accounts like 401(k)s or IRAs. But did you know that you’ll be compelled to take money out of some types of accounts once you reach a certain age? Such distributions are called Required Minimum Distributions (RMDs).
Start thinking about withdrawals early. One of the biggest mistakes you can make is waiting until age 72 to start thinking about required distributions. Remember, you can start withdrawing funds from retirement accounts without penalty after you reach age 59½. If you start planning a tax-efficient withdrawal strategy before required distribution rules kick in, you may be able to more effectively manage the tax rate applied to your retirement distributions.
Distribution amounts are based on complex tables. How much you are required to withdraw is based in part on the average life expectancy of someone your age. A calculation based on IRS life expectancy tables, plus your prior year retirement account balance, is used to determine your required withdrawals. The good news is that the financial institution handling your retirement account will usually do the calculation for you.
There are exceptions to distributions if you still work. If you reach age 72 and you are still working for an employer providing you with a 401(k), you usually don’t have to take a distribution from that account as long as you don’t own 5 percent or more of the company. However, you still must take funds from other plans where you have assets.
The one year hiatus is gone. The required minimum distribution rules were suspended in 2020 due to the COVID-19 pandemic. They are now reactivated for 2021.
Penalties are high. The rules require you to withdraw a certain amount of money every year from tax-deferred retirement plans like 401(k)s and traditional IRAs after you reach age 72, whether you want to or not. These withdrawals are then taxed as ordinary income. If you don’t follow these rules, the IRS can assess a penalty equal to 50 percent of the amount that should have been withdrawn, on top of the regular tax due.
Not all accounts require distributions. Not all retirement accounts require you to take a required minimum distribution. Roth IRA accounts, for example, avoid the minimum distribution requirement while giving you some extra flexibility to manage your other taxable withdrawals during retirement.
RMD rules can be confusing, and are a good example of why tax planning is such an important component of a retirement strategy. Please call if you have questions about any tax obligations related to your retirement accounts.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.