Updated on Friday, November 6, 2020
When you have a 401(k), you can save your money and put off paying federal taxes for years, even decades. To ensure you eventually do pay taxes on that money, the government requires you to start making withdrawals â€” your required minimum distribution (RMD) â€” from your account once you reach a specific age.
The rules around RMDs are strict, and if you donâ€™t take out the minimum amount each year, you could end up paying hefty penalties. Hereâ€™s how RMDs work and what you can do to minimize your tax bill.
Required minimum distributions (RMDs) are withdrawals you have to start taking from your retirement account each year at a certain age. The RMD amount is the minimum you need to withdraw, but you can always take out more than the required minimum. If you celebrate your 70th birthday on July 1, 2019 or later, you donâ€™t have to start taking distributions until the year you turn 72.
Youâ€™re responsible for calculating your RMD and withdrawing the correct amount. You can calculate your RMD by dividing your tax-deferred retirement balance as of Dec. 31 of the previous year by the IRSâ€™s life expectancy factor:
As an example, letâ€™s say Mary is 74, unmarried and has $200,000 in her retirement account as of Dec. 31, 2019. In her case, she would use the Uniform Lifetime table to calculate her RMD. By using that table, Mary sees that her distribution period is listed as 23.8. To find her RMD, she would divide her account balance by that number ($200,000 Ă· 23.8). The result is $8,403.36 â€” thatâ€™s the amount sheâ€™d have to take out of her 401(k) account that year to satisfy the RMD rules.
RMDs are taxed as ordinary income. If you receive Social Security benefits and are wondering if Social Security benefits are taxable, keep in mind that your 401(k) RMDs can push your income into a higher tax bracket, impacting the taxes you may have to pay on Social Security.
When it comes to RMDs, itâ€™s important to understand their rules and intricacies to avoid costly penalties. Below are some key rules you should keep in mind.
The deadline for taking your RMD is Dec. 31 each year. However, you can delay withdrawing the RMD until April 1 of the year after you turn 72 if youâ€™re taking an RMD for the first time (or, in certain cases, until after the year you retire).
With your 401(k) minimum distribution, you can take out your RMD as a lump sum, or you can split it into smaller withdrawals throughout the year. Regardless of which method you choose, the withdrawals are taxed the same way.
If you take out an excess distribution â€” meaning more than the RMD â€” you cannot apply the excess to the RMD for a future year. Youâ€™ll still have to withdraw the RMD the following year, even if you donâ€™t need that money.
The penalty for not taking the necessary RMD is steep. If you skip the RMD or take out less than youâ€™re required, the IRS will charge you a penalty that is 50% of the amount not taken on time. For example, if your RMD is $10,000 but you only took out $5,000, you would pay $2,500 in penalties (50% of the amount not taken out).
If you have multiple retirement accounts, such as a 401(k) and an Individual Retirement Account (IRA), you may be thinking about taking out one RMD from a specific account rather than taking distributions from each account. When it comes to IRAs, you must calculate the RMD separately for each one, if you have multiple accounts. You can then withdraw the total amount from one or more of your IRAs. However, your RMD from your 401(k) must be taken separately from the RMD you take out of your IRAs.
If you withdraw your RMD and donâ€™t need the money for your living expenses, you may be considering reinvesting your withdrawal. However, RMDs cannot be rolled over into another tax-deferred account.
RMDs are taxed as ordinary income, and you may owe both federal and state income taxes. There are three different ways to pay your taxes:
If youâ€™d like to avoid RMDs, there are two strategies you can use:
While you can be exempt from RMDs if youâ€™re still working or you convert your 401(k) to a Roth IRA, there are no other exceptions. However, if you miss an RMD, you may be able to have the penalty waived if you can prove the shortfall was due to a reasonable error and show that youâ€™re making steps to resolve this problem.
To have the penalty waived, you must complete Form 5329 and attach a letter of explanation.
To help people affected by the coronavirus pandemic and the corresponding economic recession, the government passed temporary measures in the coronavirus relief bill (known as the Coronavirus Aid, Relief and Economic Security (CARES) Act) that affected RMDs and retirement accounts: