Worried About Your Upcoming RMDs? - Here's What You Need to Know

The mere mention of the IRS can send chills down the spine of even the most law-abiding citizens. Despite being confident that they’ve done nothing wrong, the fear of those three letters is almost universal. It's a natural reaction, even if you tell yourself there’s nothing to worry about.

Receiving a letter from the IRS can trigger immediate stress, making you second-guess past financial decisions, deductions, or expenses claimed years ago. It’s an anxiety many of us share, as none of us want to be on the radar of the IRS.

As we transition into retirement, another acronym starts to loom large: RMD, or Required Minimum Distribution. This IRS-mandated requirement can seem daunting, but understanding the basics can help ease the anxiety.

Understanding Required Minimum Distributions (RMDs)

When we start saving for retirement, typically at a young age, we enter an agreement with the IRS. This agreement allows us to defer taxes on certain income by contributing to qualified accounts like IRAs and 401(k)s. This tax deferral helps us save more and benefit from compounded growth over time.

However, the IRS eventually wants its share of taxes on these deferred funds and their earnings. This is enforced through RMDs, which require you to start taking distributions from your retirement accounts at a certain age, thus paying taxes on these withdrawals at ordinary income rates.

What Are RMDs?

RMDs are the minimum amounts you must withdraw from your qualified retirement accounts each year starting at a certain age. These distributions are taxed as ordinary income. The pre-tax contributions and the interest earned in these accounts are subject to RMD rules. Even after-tax contributions to qualified accounts can be subject to RMD on the earnings generated.

Which Accounts Are Affected?

RMD rules apply to all employer-sponsored retirement plans, including profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans, as well as traditional IRAs and IRA-based plans like SEPs, SARSEPs, and SIMPLE IRAs.

Key Timelines and Recent Changes

The age to begin RMDs has changed over the years. Originally, it was 70½, but the SECURE Act of 2019 changed it to 72. The SECURE Act 2.0 of 2022 further increased the age to 73 for those turning 72 in 2023 or later, and it will rise to 75 by 2033.

You must take your first RMD by April 1 of the year following the year you turn 73 (if you reach age 72 after December 31, 2022). Subsequent RMDs must be taken by December 31 each year. If you delay your first RMD to April 1, you will need to take two distributions that year, which could increase your taxable income significantly.

Managing Investments for RMD Optimization

Effectively managing your investments to optimize for RMDs is crucial. By strategically planning your withdrawals and investment allocations, you can minimize the tax impact. This might involve adjusting your asset allocation to ensure you have enough liquid assets to cover your RMDs without disrupting your overall investment strategy. An experienced retirement planner can help tailor these strategies to your specific situation.

Consolidating Retirement Accounts

Consolidating multiple retirement accounts, such as 401(k)s and IRAs, can simplify tracking and managing your RMDs. Instead of juggling multiple accounts, you can have a clearer view of your total retirement savings, making it easier to ensure you meet your RMD requirements. This consolidation can also reduce administrative fees and streamline your overall financial management.

If you have an old 401(k) and are unsure what to do with it, our blog post on 4 Options to Consider with Your Old 401k Plan offers valuable insights on making the most out of your retirement savings. Combining this knowledge with account consolidation can set you up for a more organized and stress-free retirement.

Roth IRA Conversions

Roth IRA conversions are another strategy to consider. While traditional IRAs are subject to RMDs, Roth IRAs are not required to take minimum distributions during the account holder’s lifetime. Converting a portion of your traditional IRA to a Roth IRA can reduce the amount subject to RMDs, potentially lowering your taxable income in retirement. However, this strategy requires careful planning, as conversions are taxable events.

Exceptions and Special Cases

If you are still working at age 73 and participating in an employer-sponsored plan, you might be able to delay your RMDs until April 1 of the year after you retire. This exception, often referred to as the "still working exception," provides significant flexibility for individuals who choose to extend their careers beyond the typical retirement age. It's important to note that this exception is only available if you do not own more than 5% of the company sponsoring the retirement plan. This provision ensures that key employees and major stakeholders are still required to take RMDs, maintaining fairness in tax deferral benefits.

This exception does not apply to IRAs, meaning that regardless of your employment status, you must begin taking RMDs from your traditional IRAs once you reach the required age. The same holds true for other types of individual retirement accounts such as SEP IRAs and SIMPLE IRAs. Therefore, if you have multiple types of retirement accounts, it's crucial to understand the specific rules that apply to each one.

Penalties for Missing RMDs

Failing to take your RMD can result in hefty penalties, making it essential to stay on top of your distribution schedule. Previously, the penalty for not withdrawing the required minimum distribution was a steep 50% of the amount that should have been withdrawn. This punitive measure served as a strong deterrent against missing RMDs.

However, the SECURE Act 2.0 has brought some relief. Under the new regulations, the penalty has been reduced to 25% of the amount not withdrawn, which is a significant decrease but still substantial enough to encourage compliance. Additionally, if the mistake is corrected within two years, the penalty can be further reduced to 10%. This provision offers a more forgiving approach, recognizing that errors can occur and providing a path to mitigate the financial impact if corrective action is taken promptly.

Steps to Avoid RMD Penalties

To avoid these penalties, it is crucial to stay informed about your RMD schedule and ensure timely withdrawals. Here are some steps you can take:

1. Set Reminders: Mark your calendar with important RMD dates and set reminders to ensure you don't miss the deadlines.

2. Automate Withdrawals: Consider setting up automatic withdrawals from your retirement accounts to ensure you meet the RMD requirements without fail.

3. Consult with a Professional: Working with a retirement planner can help you stay on track with your RMDs. They can provide guidance on the timing and amount of withdrawals, helping you avoid costly mistakes.

4. Regular Account Reviews: Periodically review your retirement accounts to ensure all necessary actions are being taken. This can help you catch any potential issues early.

Roth IRAs and RMDs

As mentioned previously, Roth IRAs are not subject to RMDs during the account owner's lifetime, which is a significant benefit. This means that you can let your investments grow tax-free for as long as you like, without being forced to withdraw funds at any specific age. This flexibility can be particularly advantageous for those who want to maximize their tax-free growth potential or leave a larger inheritance for their beneficiaries.

However, Roth 401(k)s and 403(b)s have different rules. These accounts are still subject to RMDs, requiring account holders to start taking distributions at the same age as traditional retirement accounts. Fortunately, starting in 2024, this requirement will be eliminated, aligning Roth 401(k)s and 403(b)s more closely with Roth IRAs. This change is part of the SECURE Act 2.0 and represents a significant shift in retirement planning, offering more flexibility for those with Roth employer-sponsored plans.

Given these changes, it may be worthwhile to reassess your retirement plan and consider consolidating your retirement accounts to take full advantage of the benefits offered by Roth IRAs. This could involve rolling over your Roth 401(k) or 403(b) into a Roth IRA, thus eliminating the RMD requirement and providing greater control over your retirement savings.

Conclusion

Facing RMDs can be intimidating, but with the right knowledge and planning, you can manage them effectively. If you’re nearing the age for RMDs and find the process confusing, consider consulting with a qualified retirement planner.

At Haywood Wealth, our expert wealth management advisors can help you develop a comprehensive retirement plan that addresses RMDs, taxes, and retirement income.

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Schedule a call with our team today, and let’s build a strategy tailored to your needs and goals.