Jamie Hopkins, Managing Partner, Wealth Solutions
Qualified retirement plans – such as 401(k)s, 403(b)s and IRAs – offer clear tax advantages. Traditional 401(k)s, 403(b)s, and IRAs offer a tax deferral on contributions and growth until distribution. Their Roth counterparts can provide an inverse benefit: Contributions are taxed up front, but growth and qualified distributions are tax-free.
To prevent individuals from taking advantage of the tax-deferred growth in perpetuity, there are certain rules in place. One of those is the Required Minimum Distribution (RMD) rule. Taxpayers with qualified retirement accounts are required to start taking distributions from the accounts once a certain age is reached. That age was 70½ prior to 2020, 72 from 2020 to 2022, and will be 73 starting in 2023 with the passage of the SECURE 2.0 Act. The bill also includes a provision to increase the RMD age in ten years to 75.
Note: those who are beneficiaries of inherited retirement accounts may also be subject to RMDs, but that topic is not covered here.
The RMD rules apply to all employer-sponsored qualified retirement accounts (401(k)s, 403(b)s, etc.) and IRAs, with exception of Roth IRAs – and beginning in 2024, due to the SECURE 2.0 Act provisions, Roth 401(k)s.
If someone is still working at or beyond the RMD age and their company offers a qualified retirement plan such as a 401(k), the distribution requirement for that plan specifically is deferred until the person retires or otherwise stops working for that company. If you own more than 5% of the company when you hit your required beginning age you would still need to take RMDs from that company plan.
Due to the mechanics of the RMD age increase from 72 to 73 in 2023, a smaller subset of people will be required to take their first distribution in 2023. If you turned 72 in 2022, your first RMD would need to come out by April 1, 2023 and a second RMD, for 2023, would need to be distributed by December 31, 2023. Thus, the only people required to take their first RMD in 2023 will be those who continued to work past the RMD age and are retiring in 2023.
The RMD amount – the minimum amount that must be withdrawn and subject to tax – is calculated using life-expectancy tables provided by the IRS. The intent is to draw down tax-advantaged retirement accounts over the life of the taxpayer. As a result, the minimum distribution amount will change every year depending on the current age factor and the prior year’s distributions and market performance.
The minimum distribution is required to be taken by year-end, with one exception. In the first year an RMD is required to be taken, there is a three-month grace period and the distribution needs to be taken by April 1st of the following year to avoid penalty. The second year’s RMD is still required to be taken that year, so this does result in two distributions the second year.
The RMD age should not be confused with the age 59½ threshold, which is when an individual can start taking distributions without penalty.
How to Calculate Your RMD Amount
As noted above, the minimum distribution is calculated by using a formula based on a life expectancy factor provided by the IRS, which can be referenced in IRS Publication 590-B. The factor is primarily based on age, but also the spouse’s age, if applicable. Most people will use the Uniform Life Expectancy Table, but those with spouses 10+ years younger who are the sole beneficiaries of the account are subject to the Joint Life and Last Survivor Expectancy Table, which takes into account that the younger spouse may live significantly longer and may rely on the inherited assets well past the death of the first spouse.
To calculate the RMD, the balance of the applicable accounts on the last day of the prior tax year (December 31, 2022 for 2023 distributions) is divided by the life expectancy factor. While there is not a requirement to take distributions from every single account, i.e., a distribution from one IRA can suffice for all IRAs, there is a distinction between IRAs and employer-sponsored accounts. If you have IRAs and a 401(k), two pro rata distributions must be taken: one from an IRA to meet the RMD for the collective IRAs and one from the 401(k) to cover for the employer-sponsored plan(s).
For a simple example, assume you are 73, single or have a spouse the same age and have $50,000 in a 401(k) and $50,000 in an IRA for a total of $100,000. Your life expectancy factor is 26.5. Divide $100,000 by 26.5 and your total RMD for the year is $3,774, and furthermore, at least $1,887 is required to be withdrawn from each account.
How to Take the RMD
To take the distribution, you must direct the account custodian to make the distribution. There will be a form to fill out, which includes how much to withdraw, when to withdraw, how and where the distribution will be paid, and how much in taxes to withhold. The default federal tax withholding is 10%, but you can request specific amounts or percentages to be withheld for federal and state taxes.
Some custodians will allow you to set up automatic distributions, which can be helpful if you have multiple and/or smaller accounts to ensure the RMD is not missed.
For tax reporting purposes, you will get a 1099R that lists the distributions and taxes withheld. You should always provide this form to your tax preparer.
Prior to 2023, failing to take the RMD could result in a costly 50% penalty on the minimum distribution not taken. Due the SECURE 2.0 Act, the amount not withdrawn is now penalized at 25%, with a reduction to 10% if corrected in a timely manner.
Choosing an RMD Strategy for You
In the first year, although you have grace period, it generally makes sense to take the first RMD to reduce the overall tax liability. However, in certain circumstances, it could be worth considering a delay until the following year. As examples, if you are retiring this year with a sizeable severance package or you expect to have significant gains (perhaps from the sale of property), it could make sense to defer the income to the following year. You will double up on your RMDs in 2024, but you’ll be paying less in taxes overall if properly planned.
A very common planning strategy involving RMDs is to use them as a vehicle to withhold taxes. Once you have a good idea of what your net tax liability will be for the year – typically in November or December – you can take your distribution and withhold the necessary taxes needed for the year. The custodian will then pay federal and state tax authorities and remit the balance to you. This is generally more attractive than making estimated tax payments during the year because the tax withheld from your RMD is considered ratably paid throughout the year and can reduce the chance of an underpayment penalty due to a timing mismatch between income and estimated payments.
There is no limit on the number of distributions you can pull throughout the year, other than what your custodian may impose. You can take them yearly, monthly, or even bi-weekly if you wish, to cover living expenses. Additionally, there is no maximum distribution other than the account’s balance. If, for example, your RMD is $100,000, but you need $120,000 for living expenses, you can withdraw $120,000 or more to meet your needs. Perhaps a monthly distribution of $10,000 is more attractive. On top of those distributions, you could take a year-end distribution to cover the expected tax liability.
Consult with Your Advisors
Given the complexity of the RMD calculation and process, you should always consult with your financial planner and/or tax advisor to discuss how much to withdraw, how much to withhold, and when to take to the distributions as you near age 73.
Jamie is not registered with CWM, LLC as an investment advisor representative and does not provide product recommendations or investment advice.
Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty. For a comprehensive review of your personal situation, always consult with a tax or legal advisor. CWM, LLC, any other named entity or any of their representatives may not give legal or tax advice.