Retirement accounts, like IRAs or 401Ks, were originally set up to replace pensions, creating a new way to provide an income in retirement. For that reason, during working years, these accounts are very tax advantaged to encourage people to utilize them.
These retirement accounts were not intended to be savings accounts, and the government has a plan for distributing the money if you do not have a plan for yourself: required minimum distributions.
IRAs: Calculating your RMDs
Waiting until age 72 to start withdrawing money from your IRA/401k seems like smart tax strategy on the surface, but when you view it over a lifetime it creates a tax problem for your heirs.
What are Required Minimum Distributions?
Required minimum distributions, or RMDs, are the minimum amount of money you are required to take out of your qualified retirement accounts after you reach age 72.
While RMDs used to start at age 70, the Secure Act, enacted in 2020, pushed the age back until 72.
If you do not take the amount required of you, the IRS charges a large penalty: any shortfall is subject to a 50% penalty tax.
How do I calculate my Required Minimum Distributions?
RMDs are going to be recalculated every year. The exact amount is unique to you and will change as the amount in your accounts change.
Through your 70’s, the required amount will be pretty low, but it will increase as you age, especially if you just take the minimum every year.
While RMDs involve much more than just the raw calculation, the formula used is pretty simple.
First, you need to determine the year you are taking the distribution for. For those turning 72, you can delay your first distribution until April 1st of the year following the year you reach age 72. After that, all distributions should be made by December 31st of each year for which they are being taken.
Second, you need to find the total balance in all your retirement accounts. With RMDs, it does not matter how many accounts you have, you just need the total in all of them. The great thing about this is that you aggregate most accounts and take the required amount out of any account you want, the distributions do not need to be spread over accounts.
Next, you need to determine the life expectancy factor. You can use the Uniform Lifetime Table by the IRS to find this. If your spouse is more than 10 years younger than you, you will most likely need to use the Joint Life Expectancy Table. Make sure to look up the age you will be at the end of the current year.
Now you do the math. You divide your retirement balance by your life expectancy factor. The result is your RMD for the year.
For example, say we have Ron who is 73 and has $100,000 in his IRA on December 31, 2021. To find his RMD, we take $100,000 and divide it by the life expectancy factor for a 73-year-old, which is 24.7. This means Ron’s RMD is $4,048.58.
While this is the minimum Ron needs to take out of his retirement accounts, it might not be the best amount for him.
Listen to learn more about IRAs and RMDs:
Why should I look into my Required Minimum Distributions before retirement?
Like we mentioned above, RMDs are the government’s plan for your distributions. You will want a plan of your own, which will distribute your retirement savings over your lifetime to minimize the taxes you pay.
For many people who wait until 72 to start withdrawing, their RMDs are pretty high. They can be so high that the distributions, since they count as table income, increase their taxes a significant amount, as well as subject them to the Medicare tax IRMAA and pay more tax on their Social Security.
The smartest way to do distributions from your retirement account is to start before age 72.
At Cardinal, we help clients come up with a plan to start distributing this money out of the accounts, typically earlier than age 72. Sometimes this starts at age 65 when they retire, sometimes it starts at age 55, it really depends on the client.
We look at your current income, where you are in the tax brackets, and figure out a way for you to distribute the money out of your accounts and pay the least amount of taxes.
If your plan for this money is to leave it to your heirs, there are better ways to do this. You can purchase life insurance with this money, which will leave them a tax free inheritance. You can also put this money in a Roth IRA, through a Roth conversion, which would also pass tax-free to your heirs.
RMDs are the government’s plan for your money; coming up with your own plan, with the help of professionals, can result in you keeping thousands of dollars of your hard saved money instead of losing it to taxes.
