Required Minimum Distributions for 401(k) Plans

Planning for retirement involves understanding your full financial picture. One important aspect of this is the concept of Required Minimum Distributions (RMDs). Navigating the complexities of RMDs is crucial to avoiding potential penalties and maximizing your retirement income.

RMDs represent the minimum amount that retirees must withdraw from their retirement plans each year. These plans may include defined contribution plans (such as 401(k)s), profit-sharing plans, and other tax-deferred retirement accounts.

The IRS mandates that required amounts be withdrawn to ensure that retirement funds are properly taxed within a reasonable period of time. When you withdraw funds, you’ll be liable to pay ordinary income tax on the total amount of the distribution.

This article will explore what RMDs are, why they’re required, how you calculate an RMD amount, and more.

What Is a Required Minimum Distribution (RMD)?

RMDs refer to the minimum amounts that the Internal Revenue Service (IRS) mandates you withdraw each year from tax-deferred retirement accounts, such as SEP-IRAs, traditional IRAs, SIMPLE IRAs, and 401(k) plans. Roth IRAs, are excluded from this condition, and in 2024, all Roth accounts (including Roth 401(k)s will be RMD-exempt.

Because RMD withdrawals are taken from tax-deferred accounts, the distributions are subject to income tax.

According to the Secure 2.0 Act, the account owner needs to begin withdrawing RMD amounts on a set schedule: the first distribution must be taken by April 1st of the year following the year you turn 73 or retire, whichever is later.

Calculating your RMD involves considering various factors, such as the account balance at the end of the previous year, the account holder’s age, and the IRS-provided life expectancy tables.

Why are RMDs Required?

RMDs are mandated by the IRS to ensure that retirees begin to withdraw—and thus pay taxes on—accumulated funds in their tax-deferred retirement accounts. It also ensures that investors won’t be able to use their retirement savings for endless tax-free growth.

RMD withdrawals are considered taxable income and can potentially affect your year-end tax bracket. One of the consequences of neglecting to take RMDs is facing steep penalties from the IRS.

As of 2023, and due to the Secure Act 2.0, the penalty imposes an excise tax of 25% on the required amount for the distribution period that failed to be withdrawn. You can knock this penalty down to 10% if you take the RMD within the “correction window”, or two years.

We will explore how RMDs are calculated more in the next section, but it’s important to know that your RMD will vary each calendar year according to the life expectancy table provided by the IRS.

Your RMD is contingent on your account balance (after distributions from the previous year) and in consideration of your projected life expectancy. You’ll receive notice of impending RMD in your first year of eligibility so that you can plan account distributions accordingly for that tax year.

Understanding potential tax implications and penalties associated with RMDs is vital to making informed retirement planning decisions.

Calculating RMDs for 401(k) Plans

Having a solid grasp on how RMDs are calculated is a crucial step in avoiding penalties and securing a successful retirement. To help retirees with this, the IRS provides life expectancy tables in IRS publication 590-B. These come in three types:

1. The Uniform Lifetime Table: Used for all unmarried account owners, married owners with a spouse ten or fewer years younger, and married owners with a beneficiary who isn’t their spouse.
2. The Joint Life and Last Survivor Expectancy Table: for owners with a spouse over ten years younger who serves as the account’s sole beneficiary.
3. The Single Life Expectancy Table: for beneficiaries who aren’t the account owner’s spouse.

The applicable life expectancy factor will depend on various factors such as the account owner’s age, the beneficiary status, and whether the account beneficiary is a spouse.

To work out your RMDs using the IRS tables, here’s a simplified process:

1. Find your account balance as of December 31st of the previous year.
2. Identify the relevant life expectancy factor from the IRS table (Publication 590-B).
3. Divide the account balance by the life expectancy factor.

If you have multiple tax-deferred retirement accounts, you must calculate this separately for each account and meet the separate RMD requirements.

• Here’s an example: Suppose an unmarried account owner is 73. They’ll use the Uniform Lifetime Table, which indicates that the distribution period at that age is 26.5. If they had $100,000 in their 401(k) at the end of the previous year, their RMD for that year is $3,774. This number would increase if they had more retirement savings.
  • With $300,000 in their account, the RMD would be $11,321 at 73. Or, if they had $300,000 but were older when they retired — let’s say 80 — their RMD would be $14,851.

Tips for Managing RMDs

There are various options for taking RMDs, from lump-sum withdrawals to annual, quarterly, or monthly distributions. The strategy you adopt when planning for RMDs in retirement should consider your projected expenses, anticipated income sources, and the tax bracket you’re likely to fall into.

Speak to your tax advisor to get a complete picture of your Social Security income and how it relates to your projected RMDs, if you have to take them.

Moreover, there are several strategies to potentially reduce taxes on RMDs:

• Donating a portion of your tax-deferred savings to charity (would need to roll your 401(k) to an IRA first to be eligible for Qualified Charitable Distributions (QCDs)).
• Convert the funds to a Roth IRA in low- or no-income years before RMDs are required.
• Utilizing Qualified Longevity Annuity Contracts (QLACs) allows you to invest a portion of your retirement savings in an annuity that doesn’t start paying out until later in life, thus reducing your RMDs and the taxes owed on them.

Exceptions to Required Minimum Distributions

There are certain circumstances where RMDs are not mandatory.

Here are some of those circumstances you should be aware of:

• Roth 401(k) plans: As of 2024, RMDs will no longer apply to Roth 401(k) accounts while the account owner is still alive.
• Delayed retirement: If you’re still employed and participating in your employer’s retirement plan, RMDs can be delayed until you retire. However, this exception does not apply if you own more than 5% of the company.
• Money converted to a Roth IRA: While you’ll pay tax up front on any amount converted, money in a Roth IRA is not subject to RMDs during the account owner’s lifetime.

Understanding these exceptions — and how they might apply to your situation — is vital for optimizing your retirement savings strategy.

FAQs

When Do RMDs Start?

RMDs typically begin when the account owner turns 73 or upon their retirement, whichever is later. The first RMD must be taken by April 1st of the following year after you turn 73 or retire.

Are RMD Distributions Taxed?

Yes, RMDs are subject to tax and are classified as ordinary income.

What If I Don’t Take RMDs?

Not taking your RMDs can have significant financial repercussions, including a steep 25% excise tax from the IRS on the amount that should have been withdrawn but wasn’t.

In Summary

Mastering the concept of RMDs and understanding their significance in retirement planning is paramount for avoiding penalties and maximizing your retirement income. Complying with RMD rules is crucial for securing a successful and stress-free retirement.

For help managing your retirement funds by locating your old 401(k) accounts and completing rollovers, work with Capitalize. We’re a trusted partner helping make the rollover process seamless and stress-free.

Learn how we can help you set up your financial future today.