There’s a two-headed monster trying to sink two sets of teeth into the retirement accounts of unsuspecting investors.
In this “based on a true story” horror flick, one head gnaws on account balances by way of huge penalties for missed or forgotten deadlines. The second head chomps on the remaining morsels by prematurely drawing down the accounts of retirees with long lifespans.
What is this beast? It’s the Required Minimum Distribution, and it’s actually very conquerable if you know how to handle it.
What is a Required Minimum Distribution?
A Required Minimum Distribution (RMD) is the minimum amount anyone over the age of 70½ is required to withdraw annually from their retirement accounts. For employer-sponsored retirement plans such as 401(k)s and 403(b)s, RMDs can sometimes (depending on plan rules) be delayed until you retire. For traditional Individual Retirement Accounts (IRAs), you must begin taking RMDs once you turn 70½ regardless of whether you are still working. However, RMD rules do not apply to Roth IRAs while the original account owner is alive — they come into play with inherited Roth IRAs.
Your plan custodian or administrator can usually help calculate your RMD, but it’s ultimately up to you to ensure that you withdraw the correct amount each year by the deadline (typically Dec. 31).
What is the purpose of RMDs?
RMDs are compulsory for retirement accounts in which contributions were made on a pre-tax basis and earnings grew free from capital-gains taxation. These funds are subject to ordinary income tax upon distribution, so triggering distributions allows the federal government to begin collecting taxes on an otherwise untaxed pool of money.
Furthermore, without RMDs wealthy individuals who wish to leave money to heirs — and who do not need the entirety of their investing accounts to meet living expenses — could delay distributions indefinitely in order to pass tax-free dollars to their beneficiaries.
How can retirement investors avoid the monster’s first head, otherwise known as the penalty?
Every year thousands of people fail to take RMDs and end up giving more of their nest egg to the tax man. If you or someone you know is subject to RMDs in 2014, here’s the scoop:
- If you are already 70½: If you don’t complete the withdrawal by Dec. 31, you’ll incur an IRS penalty equal to 50% of your required distribution total. For example, if your RMD is $2,000 and you don’t take the distribution, your federal tax penalty would be $1,000.
- If you turned 70½ in 2014: You have until April 1, 2015, to take your 2014 distribution. If you don’t complete your withdrawal before April 1, you’ll incur an IRS penalty equal to 50% of your required distribution. All subsequent RMDs must be taken by Dec. 31 each year. Please be aware that if you wait until next year to take your 2014 RMD, that income — plus income from your 2015 RMD, which you’ll need to take by Dec. 31, 2015 — may leave you with a larger 2015 tax bill than you want.
RMD action item: Set annual calendar reminders to contact your account custodian or plan administrator for help calculating your RMD amount. The first reminder should alert you by October or early November, reminding you to request the RMD calculation. The second reminder should alert you by November or early December to complete the forms necessary to initiate the distribution before year’s end.
How can retirement investors avoid the monster’s second head, otherwise known as outliving your money?
RMD rules were designed with average life expectancies in mind. But think about this … our lifespans have increased to the point that some of us could spend more than 35 years in retirement. According to projections from the U.S. Census Bureau, approximately 20 percent of Americans will be 65 or older by the year 2050 — and of those, about 400,000 will be at least 100 years old. This translates to nearly 30 years of RMDs drawing down your nest egg.
RMD action item: If you don’t immediately need the money you withdraw to pay for living expenses, consider reinvesting your RMD funds through a taxable brokerage account or making a charitable donation that could help reduce your taxable income. Before you make any decisions about taking RMDs from your account, consult with a financial advisor and tax professional.
With lifespans increasing, it’s more important than ever for you to have enough income to maintain the kind of retirement lifestyle you want. By creating a financial plan for retirement and sticking to a disciplined withdrawal strategy, you can better help your hard-earned dollars last throughout your lifetime.
An investment advisor at Financial Engines can help you create an investing and retirement plan that includes withdrawals and RMDs. With a personalized strategy under your belt, you’ll be well on your way to defeating the two-headed monster.