If you have ever felt unsure about the inner workings of individual retirement accounts (IRAs) or wondered what happens with these accounts when you reach a certain age, you are not alone. Many have questions about required minimum distributions (RMDs) and how they affect their IRAs. Let’s address some of the fundamentals now.
What Is an IRA?
An IRA, or individual retirement account, was created under the Employee Retirement Income Security Act (ERISA) in 1974. They function like a special savings account that helps you save and invest for retirement. These accounts are meant to act as an additional income source in retirement because Social Security was never intended to be the only source of retirement income. There are different types of IRAs. The most common ones are Traditional and Roth IRAs.
- Traditional IRA: In its simplest form you contribute pre-tax money allowing for a possible tax deduction. The account grows tax-deferred, and taxes are paid upon withdrawal in retirement.
- Roth IRA: You contribute money after paying taxes. The account grows tax-free, and withdrawals are tax-free in retirement.
If you have questions about which would be suitable for you, please reach out to your financial advisor. Also note that the IRS has income limits on the deductibility of traditional IRA contributions, and the IRS likewise has income limits on the ability to contribute directly into Roth IRAs.
What Are RMDs?
Now, let’s delve into the basics of RMDs. Simply put, RMDs are the government’s way of making sure you eventually pay taxes on your Traditional IRA. These distributions exist as a tradeoff for favorable tax treatment during the years of funding the account and letting it grow.
When you reach a certain age, called the required beginning date (RBD), the IRS requires you to start withdrawing a minimum amount from your Traditional IRA each year. This amount is your RMD. Currently, the required beginning date is 73 years old. (Inherited IRAs have different rules, and their RMDs depend on a few factors. Please ask your financial or tax professional for details if you have an Inherited IRA and need clarification about RMDs.)
RMDs are required for all tax-deferred retirement accounts, including Traditional IRAs, SEP-IRAs, and SIMPLE IRAs. RMDs are required for workplace accounts, such as 401(k)s and 403(b)s. However, these accounts generally allow you to defer distributions while you are still working.
How Are RMDs Calculated?
RMDs are based on your age and the balance in your IRA at the end of the previous year. The IRS prescribes a formula, which is based upon those two variables. The older you get, the higher proportion of the IRA you must withdraw each year.
In part two of this article series, we will discuss the changes the SECURE Act 2.0 of 2022 made to RMDs. Do not worry; you do not have to memorize the details yourself! Your financial advisor can help you navigate what you might need to do.
What Happens If You Do Not Take Your RMD?
If you do not take out your RMD, you could face a hefty penalty of 25% of the amount you were supposed to withdraw. So, if your RMD is $10,000 and you do not take it out, you could owe $2,500 in penalties. Ouch!
What About Roth IRAs?
There is some good news for Roth IRA holders. Roth IRAs do not have RMDs during the original account owner’s lifetime. Since you have already paid taxes on your contributions, the government does not require you to withdraw the money.
Key Takeaways
- Start Early: Know when you need to start taking your RMDs (currently by April 1 of the year after turning 73). Functionally, it’s likely to be in your best interest to take your first RMD by December 31 of the year you turn 73. Taking your first RMD between January 1 and April 1 of the following year, although allowed, means you’d have to take two RMDs during that same tax year because you’ll have to take your age 74 RMD that year too.
- Plan Ahead: Work with a financial advisor and tax adviser to make sure you are prepared for your RMDs and have a strategy in place. RMDs will impact your taxable income. Consider having tax withholdings from the distributions.
- Know the Difference: Understand the difference between Traditional and Roth IRAs and how RMDs apply to each.
By understanding the basics of an IRA along with how RMDs work you can go forward with confidence in managing your retirement savings. Let us know if we can help. Our aim is to alleviate worries so you can enjoy retirement with peace of mind.