While many 401(k) participants are warned of the early withdrawal penalties for 401(k) accounts, fewer people might know about the penalties for not withdrawing enough once you reach age 72. After that year, you’ll need to withdraw a 401(k) required minimum distribution (RMD) every year, or face a tax penalty of up to 50% of the unclaimed distribution.
For defined contribution plans like traditional IRAs, SEP IRAS, SIMPLE IRAS, 401(k) plans, 403(b) plans, 457(b) plans, profit-sharing plans, and other plans in which the money in the account is untaxed, RMDs are a way to ensure taxes get paid on the money.
The age at which RMD starts—72—has gone up recently. In 2019, the Setting Every Community Up for Retirement Enhancement Act (SECURE) changed the required age for RMDs from 70 1/2 to 72. With that change, anyone who reached the age of 70 1/2 before January 1, 2020, should have expected required minimum distributions to kick in that year.
However, when the pandemic hit in early 2020, RMD rules were suspended under the CARES Act. The IRS also allowed for people who had already withdrawn an RMD from their account to pay back the money into their retirement fund. As of now, there have been no further discussions as to whether this moratorium will extend into 2021, so it may be a good idea to pay attention to the news and any policy changes prior to taking out an RMD for 2021.
How Are Required Minimum Distributions Calculated?
Depending on payout options, some retirees choose to roll over their 401(k) into an IRA. But before deciding if that’s the right move, it can be helpful to know the basic 401(k) required minimum distribution rules.
RMDs are calculated in such a way that an individual should have spent their IRA by the time they pass away. While this is obviously not an exact science, this is done by dividing the worth of the portfolio by what is called a “life expectancy factor.”
The IRS has a worksheet for individuals to figure out their RMD, including a chart that maps distribution over projected life expectancy, based on current age. For example, a 75-year-old has a life expectancy factor of 22.9. If that person has a portfolio valued at $500,000, they’d have to withdraw an RMD of $21,834 ($500,000/22.9) from their account that year. Generally speaking, the older a person is, the larger the RMD they’ll need to withdraw. RMDs can be withdrawn in one sum or numerous smaller payments over the course of a year, as long as they add up to the total amount of your total RMD requirement.
If a spouse is the sole beneficiary on the 401(k) account and is more than 10 years younger than the account holder, a different table is used to calculate the RMD. Generally, this means an RMD might be lower, so that there would be money left in the account for the spouse if the account holder were to die.
An investor with multiple IRA accounts would have to calculate the RMD for each of the accounts, but would not have to take that amount out of each account. It’s possible to combine RMDs, withdrawing the funds from just one account.
Individuals can also decide how they want their RMD allocated—for example, some people take a proportional approach to RMD distribution. This means a person with 30% of assets in short-term bonds would choose to have 30% of their RMD come from that investment category.
Deciding how to allocate an RMD gives an investor some flexibility over their finances. That’s why it’s good for an investor to have a sense of when and how much will be required of their RMD. Once they know, they can then come up with a plan for what to do with the funds.
RMD Requirements for IRA Beneficiaries
Some people assume that RMDs are only for people near retirement age. But RMDs are usually required for IRA beneficiaries as well. Beneficiaries also need to consult a beneficiary table to ensure they’re taking out the proper amount from the account each year.
Any beneficiary who inherits an IRA after January 1, 2020, will need to withdraw the entirety of the account within 10 years of inheriting the account, as set forth in the SECURE Act. That timeline shortens to five years if the account is inherited before the original account owner took out distributions (for example, if the account owner died prior to age 72, then the beneficiary will have five years to withdraw from the account).
In certain cases, beneficiaries are categorized as “eligible designated beneficiaries.” These are people including minors, disabled individuals, surviving spouses, and account owners less than 10 years younger than the original account holder. These beneficiaries do not have the same timeline requirements for distribution, and in many cases, can take distributions based on their own expected life expectancy. The exception to this rule is children who were minors at the time of inheritance. Once they turn 18, the clock begins ticking and they must withdraw RMDs according to the designated beneficiary rules.
How a Roth Conversion Affects RMDs
While a 401(k) grows tax-free during the course of an investor’s working years, the RMDs withdrawal is taxed at their current income tax rate. So in some ways, an investor is only delaying a tax bill by growing their 401(k).
One way to offset tax liability is for an investor to consider converting a 401(k) into a Roth IRA in the years preceding mandatory RMDs. This can be done at any point during an investor’s life.
Because a 401(k) invests pre-tax dollars and a Roth IRA invests taxed dollars, an individual will have to pay taxes right away on the 401(k) funds they convert to a Roth. The good news is, upon withdrawing the money after retirement, they don’t have to pay any additional taxes. Paying your tax bill now rather than in the future can make sense for investors who anticipate being in a higher tax bracket during their retirement years than they are currently.
Converting a 401(k) can also be a way for high earners to take advantage of a Roth. Traditional Roth accounts have an income cap (people filing individually need to have a modified adjusted gross income (MAGI) of less than $139,000 to open a Roth) and Roth accounts also limit contributions per year. But these rules don’t apply for Roth conversions (thus they’re sometimes called a “backdoor Roth IRA”).
Once the conversion occurs and a Roth IRA account is opened, an investor needs to follow Roth rules: In general, withdrawals can be taken out after an account owner has had the account for five years and the owner is older than 59 1/2, barring outside circumstances such as death, disability, or first home purchase.
What Should an Investor do With Their RMDs
How you use your RMD depends on your financial goals.
• Some people may use their RMDs for living expenses, especially if they are in their retirement years.
• Other people may use their RMDs to fund a brokerage account.
• It’s also possible to directly transfer your RMD into a taxable account.
• While an investor will still owe taxes on the RMD, they will then be able to stay invested in the securities in the previous portfolio.
• Investors also may use part of their RMD to donate to charity.
• If the funds are directly transferred from the IRA to the charity (instead of writing out a check yourself) the donation will be excluded from taxable income.
Finally, reinvesting RMDs can provide a growth vehicle for retirement income. For example, some investors may look to securities that provide a dividend, so they can create cash flow as well as maintain investments. While there is no “right” way to manage RMDs, coming up with a plan can help ensure that your money continues to work for you, long after it’s out of your original 401(k) account.
Investors facing RMDs may want to fully understand what the law requires before withdrawing money unnecessarily. As the recent CARES and SECURE acts have made clear, no tax law is set in stone. And even if RMDs seem a long way off, it can be helpful for any investor to consider different avenues for growing that money once they start withdrawing in retirement.
As always, coming up with a financial plan depends on knowing one’s options and exploring next steps to find the best fit for your money. If you’re opening a retirement account such as an IRA or Roth IRA, you can do so at a brokerage, bank, mutual fund house, or other financial services company, like SoFi Invest®.
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