The old proverb, “You can’t take it with you,” refers to the idea that money and possessions are earthly things and cannot accompany a person in death. Further interpretation suggests that people should not hoard money and live life to the fullest. While no financial advisor would recommend that retirees spend their money irresponsibly, even retirement accounts don’t allow their owners to store their money indefinitely. Account holders must withdraw a specified amount of money by law at age 73 under a provision known as Required Minimum Distributions (RMDs). Understanding the rules and deadlines surrounding RMDs and using practical approaches to manage them can allow retirees to experience the true meaning of the adage, enjoying life as much as possible with the money they have.
How are RMDs Calculated?
The Internal Revenue Service (IRS) uses a simple formula to determine the mandatory withdrawal amounts: The account total on December 31st of the previous year divided by a life-expectancy factor derived from IRS-established tables. For example, an individual with an account balance of $500,000 with a life expectancy of 25 years would have an annual RMD of $20,000.
Why Do RMDs Exist?
As much as retirees may want to hold on to their money for potential needs further down the road, 401(k)s, 403(b)s, and traditional individual retirement accounts (IRAs) are tax-advantaged. Pre-tax contributions feed these accounts, which means the government still needs to collect tax on those funds. RMDs guarantee that the government receives the tax revenue from those accounts. Without RMDs, funds could go untouched in some accounts indefinitely and even pass to the next generation.
What are the Consequences of Not Taking RMDs?
Considerable financial penalties can result from a failure to take RMDs. Additionally, RMDs have deadlines, so not only must an account holder take them, but they must do so within a specified timeframe. Current IRS regulations apply a 25% excise tax to amounts not withdrawn as required from applicable retirement accounts. For example, an annual RMD of $20,000 will carry a $5,000 penalty if the account holder does not withdraw on time. Income tax on the entire RMD amount will also apply at the eventual withdrawal time.
RMDS and Roth Accounts
In 2024, the Secure Act 2.0 granted an exception for RMDs on designated Roth 401(k) accounts, which means that as of 2024, RMDs do not apply to Roth 401(k) and the historically exempt Roth IRA accounts. Roth accounts are the way to go for long-term retirement planning from a tax mitigation and RMD perspective. They allow for tax-free growth minus the pressure of mandatory withdrawals.
Inherited Accounts and RMDs
The Hollywood movie version of inheritance never includes the unsexy side: taxes and RMDs. Beneficiaries come into inherited money and go from rags to riches with a fairy tale ending. The truth about inherited accounts is that they may require immediate RMDs, which could have significant tax implications depending on the relationship between the beneficiary and the deceased and the type of account.
Non-spouse beneficiaries are typically required to withdraw the entire balance of an inherited account within 10 years. The withdrawals incur income tax, and large sums could impact the recipient’s tax bracket. A financial advisor can help beneficiaries time their withdrawals to minimize tax burden as much as possible.
The Benefits of Planning for RMDs in Retirement
Creating a withdrawal strategy with a financial advisor can help retirees navigate the complexities surrounding RMDs to align with their broader economic goals. For example, retirees can designate their RMDs for essential expenses like healthcare. Individuals can also reinvest their RMDs in stocks, bonds, or another taxable brokerage account to further grow their wealth. Other advantages of an optimized RMD approach include:
- Preventing large penalties and unnecessary taxes
- Maximizing retirement income
- Building a financial legacy to leave to loved ones
RMDs are more than another tax rule to follow. They present an opportunity to manage taxes, maximize savings, and ensure a comfortable retirement that lasts all your days.
At SHP Financial, we guide our clients through the five planning areas of their Retirement Road Map® to form a comprehensive strategy that includes RMDs and the tax implications that accompany them. To learn more about how RMDs fit into your retirement plan, contact our experienced advisors at SHP Financial today. We’ll start with a complimentary review of your finances.
