Finance 101: Required Minimum Distributions

It’s not too early to start thinking about them.

As many Americans know, they will be required to take a mandatory minimum distribution from their tax deferred accounts at age 70.5. So what should you think about when you think about Required Minimum Distributions (RMD)?  

What a lot of people may not think about is how to plan for their RMDs and some of the things to watch out for. For today’s discussion I will limit myself to Defined Contribution plans (401ks, 403bs, self employed plans) and IRAs and how they are different in important ways.

First you need to have a plan. You will have to take the distribution even if you don’t need the money, so it pays to think ahead.

Does it just get sent to me?

IRAs and employer-sponsored plans deal with RMDs differently. Plans may or may not send the RMD automatically, so contact them to understand their policy. IRAs need to be contacted and instructed as to how you want to receive an RMD.

Do you need the RMD for  your planned spending? If not then perhaps you should think about how you can decrease the RMD or eliminate it so you won’t be taxed on it — I’ll touch on this later.

How will you take the money out? For plans, always check to see if paperwork is required — some 403b plans actually make you file paperwork each year. Don’t assume you can just call in. Most IRAs do not require paperwork.

Can you choose from which investments your RMD is drawn? For most plans the answer is no, but most IRA’s allow you to choose which investments you can draw the RMD from. Many people like this flexibility.

Do you want one lump sum? A monthly check? Something else? Some people prefer getting their RMD late in the year to keep that money invested, which is ok. I think it’s a good approach to get it in monthly installments. You averaged into the account, why not average out?

Can you aggregate your RMDs? Not from most plans (some 403bs allow this), an RMD must be taken from each plan you have. You can take your RMD from an IRA by aggregating the total needed to satisfy the RMD. This means if you had three IRAs you can take the full required amount from one or split between accounts. This allows you some flexibility to select the most preferable account or investments to draw from. Generally you cannot select where you draw the RMD in retirement plans, so they lack flexibility in that regard.

How will you handle taxes? The IRS allows you to choose the tax withholding at the time of withdrawal including no taxes at all. This is simply on the taxes withheld at the time of the withdrawal, not how much you may ultimately owe in taxes on that income.

Other things you may want to consider

There are a many wrinkles in the rules for RMDs from the plans themselves and from IRS codes so consider the following:

You’re better to take the distribution when it is required. Not doing so will bring a 50 percent IRS penalty on the amount that should have been taken.

*If you will not need the RMD you will still need to take it unless you start taking steps. One of the only ways to reduce or eliminate the RMD is to consider doing Roth conversions. This is simple for most IRAs but plans are subject to many withdrawal rules. When doing a Roth conversion it means moving money from a plan or IRA into a Roth IRA. It creates taxes now but lowers/eliminates RMDs in the future. Doing this over many years allows you to manage your taxes that you will incur. As always check with your accountant if this is of interest.

What happens in the RMD calculation if you have a Roth or after tax money?

*If you have charitable intentions and do not need the RMD you can make a direct contribution to a qualifying charity from an IRA. This allows you to not report the income on your tax return. You cannot do this from any type of employer plan.

*If you have either Roth 401k money or after tax money in your retirement plan it will still have to be paid out as part of the RMD. This is a pain point for many people. The money was tax advantaged in the plan but must now go out into the taxable world. Not ideal. This is also true for IRAs regarding after tax money. Also of note if you do have Roth and/or after tax money in a retirement plan you can roll the plan over to an IRA and put the Roth/after tax money in a Roth IRA and no longer have the RMD on that money.

*If a spouse has an inherited retirement plan and RMDs are to be paid, the calculation of the amount changes, and not for the better. The IRS rules require that a different table be used, called the single life or beneficiary table. This creates an RMD approximately 40 percent larger and creates some undesirable effects. It speeds up the drawdown of the account and speeds up the taxation. More often than not a surviving spouse will need less money annually, not more. So this is both tax inefficient and leaves less for the estate.

So to quickly summarize, start developing a plan for your RMD many years before you are required to take it. This allows the best amount of time to actually think about and plan for what you want. Also be aware of the many wrinkles of plan and IRS rules regarding RMDs to avoid headaches and penalties.

Finally, I would suggest that all of the above supports considering moving plan assets to an IRA: It provides flexibility, possibly better tax treatment, protection to spousal beneficiaries from taking more than needed and all the other benefits of having an IRA.