Understanding Required Minimum Distributions

There’s certainly a danger in taking too much money out of your investments after you retire. But when it comes to tax-advantaged accounts like IRAs and 401(k)s, withdrawing too little can also be a mistake.

The reason: required minimum distributions, or RMDs. The IRS mandates that you pull out a certain portion of your tax-advantaged retirement funds once you hit age 70½. Otherwise, you’re slapped with a whopping 50% federal tax penalty on the mandated withdrawals – on top of the ordinary income tax rate you’d normally pay.  Ouch.

These mandated distributions only apply to traditional IRAs that received pre-tax contributions and to both types of 401(k)s – Roth and regular. Roth IRAs aren’t taxed in retirement and aren’t subject to RMDs – at least not during the account owner's lifetime. One benefit of a  Roth 401(k): While you do have to take RMDs from it, the distributions aren't taxed. To avoid having to take RMDs on your Roth 401(k), roll it over into a Roth IRA. (One other detail, just for the record: Had you still been employed at 70½, you wouldn't have had to take an RMD from your current employer's plan.) 

What’s Your RMD?

Essentially, the annual distribution you are required to take is your account balance at the end of the previous year divided by your statistical life expectancy. The IRS has a worksheet on its website to help you calculate the exact amount. There’s a separate form if your spouse is more than 10 years younger than you and the sole beneficiary of your account. In that case, because of a spouse’s longer expected lifespan, the distribution you have to make is slightly smaller. 

The Rules for 401(k)s vs. IRAs

The rules are slightly different for 401(k)s than other retirement accounts. For example, with IRAs, you have to take your first RMD by April 1st of the year after you turn 70½. But if you’re still working, you typically won’t have to start taking withdrawals from your current employer’s 401(k) until you retire, even if you’ve already reached the cut-off age (although you do have to take distributions from a previous employer’s plan).

Also, if you have multiple IRA or 403(b) accounts, if doesn’t matter which ones you withdraw from to satisfy your RMD. As long as you calculate the required distribution for each account you own, all that matters is that you take out your cumulative RMD. 

If you have more than one 401(k), on the other hand, you need to take the RMD from each one. It’s another good reason to roll over your retirement funds into one or two accounts, which makes them a lot easier to manage.

Keep in mind that every dollar you pull out of an IRA or 401(k) is subject to the ordinary income tax rate. So if the RMD isn’t enough to meet your monthly expenses, consider reining in your spending or tapping funds from an after-tax Roth account. 

Next we’ll turn to your mortgage, and whether it makes sense to pay it off, if you still have one.