When it comes to retirement planning, many of us tend to think more about the saving part. You work hard to build up a nest egg that will carry you through the retirement years. Yet what you may not realize is, there are rules around how you spend your retirement savings.
Understanding and planning for Required Minimum Distributions (RMDs) is an important part of retiring successfully. Knowing (and following) the rules will save you stress, time, and money on potential penalties.
Read on to learn more.
Two Phases for Retirement: Strategic Saving and Strategic Spending
Retirement planning involves two stages—the first one being the accumulation phase. In the years (ok, decades) leading up to retirement, you save and “collect” the money that you plan to use later. This could be through company pensions, stocks, profit-sharing plans from your job or business, etc.
After the accumulation phase comes the fun part—the distribution phase. This is the phase of life where you get to use your hard-earned savings to enjoy the retirement lifestyle you’ve designed for yourself.
The one caveat is, you’ll have to pay income tax on RMDs and withdrawals from other retirement accounts. So, to get the most out of your money and avoid big tax penalties, strategic spending is key. This is where your understanding of RMDs, tax diversification, and withdrawal order (ie which accounts to withdraw from first) comes in.
At Wealth Legacy Institute, we use a tax diversification model called the tax triangle to help our clients spend smart and hang on to as much of their retirement savings as possible.
What are Required Minimum Distributions (RMDs) and How do They Affect Your Retirement
Required minimum distributions (RMDs) are a minimum amount that you must withdraw from your retirement accounts each year—as required by the IRS. If you don’t, you face a penalty.
Imagine this scenario: You wanted to take out $6,000 by the deadline (typically December 31). For some reason, you missed it. This means you will have to pay a 50% penalty ($3,000) to the IRS, on top of regular income taxes. That is far too much money to just let slip away.
The good news is if you know how RMDs work and you follow the rules, you can avoid these types of penalties and keep more of your retirement money for the things you love.
What Are the Rules for Taking Out RMDs?
The SECURE Act (Setting Every Community Up for Retirement Enhancement) became law on December 20, 2019. Essentially, the SECURE Act gives retirees a little more time before they have to start taking yearly required minimum distributions.
According to the IRS: If you reached the age of 70½ in 2019 the prior rule applies, you must take your first RMD by April 1, 2020. If you reach age 70½ in 2020 or later you must take your first RMD by April 1 of the year after you reach 72.
For most retirement accounts, the deadline for taking your RMDs is December 31. Except for the first year, when you have until April 1 in the year after you turn 70½ (or 72).
RMD regulations are applicable to all employer-sponsored retirement plans, including:
- Profit-sharing plans
- 401(k) plans
- 403(b) plans
- 457(b) plans
- Roth 401(k)
Rules also apply to traditional IRAs and IRA-based plans including:
- Simplified Employee Pensions or SEPs
- SARSEPs - An early version of a SEP plan that includes a salary reduction arrangement
- SIMPLE IRAs - Savings Incentive Match Plan for Employees Individual Retirement Account
How Do You Calculate Your RMD Amount?
Generally, you calculate the required withdrawal amount based on each account balance, divided by a life expectancy factor that is published yearly by the IRS. There are multiple life expectancy tables based on various life situations.
Sounds fun, right?
Thankfully, your IRA custodian or financial advisor can help you calculate your RMD amount and adhere to the deadline.
Important Note About COVID-19 and RMDs
If you’ve been hit hard by the repercussions of COVID-19, you can take a deep breath and relax. In March 2020, the U.S. Senate passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act. It includes a number of measures designed to stimulate the economy. One provision allows retirees to forgo RMDs from IRAs, 401(k)’s and other qualified accounts in 2020.
Be aware that not all relief is provided to beneficiaries of inherited IRAs. You can find more information here.
Want to know more about managing your RMDs in retirement so you can enjoy your retirement years to the fullest? Speak to a financial advisor at the Wealth Legacy Institute today.