How many times in life do you have to worry about removing too little money from a financial account? Before retirement, there are few such concerns – but, for most retirement plans, once you reach age 70½, you must take a required minimum distribution (RMD) every year from your plan. (Roth IRAs are excluded – they do not require withdrawals at any specific point until the owner passes away.)
Minimum distributions must be taken by the last business day of the year (December 28 for 2018), except for your first one. The first RMD must be taken by April 1 of the calendar year after you turn 70½. To avoid two RMDs falling in the same tax year, it's usually best to take your first distribution in the year you turn 70-1/2 rather than waiting until the following April 1.
Why April 1? Perhaps it's an IRS attempt at humor. In any case, it's important to take your RMD within the deadline every year, whether it's the original April deadline or the December deadlines thereafter. Otherwise, you will incur a 50% penalty on the amount that should have been removed from the account but was not – and that is independent of the income tax owed.
Here are a few other RMD mistakes that can waste your precious retirement funds:
- Forgetting the Rules for RMDs While Employed – If you're still working at 70½ years old, typically RMDs won't be taken from the 401(k) of your current employer. But you will have to take them from the IRAs and 401(k)s of your previous employers.
- Failing to Re-Invest – You may have to take out more money than you want, but nothing stops you from re-investing that money. You can't contribute it to a tax-deferred account, but you may be able to invest in a post-tax Roth IRA after you pay the taxes on the distribution. If all else fails, alter your remaining portfolio to be a bit more aggressive and use your RMD withdrawal funds to ladder some CDs to replace the conservative part of your portfolio.
- Errors From Multiple Accounts – Be careful when managing RMDs from multiple accounts. You can take your required IRA total from any one IRA or combination of IRAs, but each 401(k) has its own RMD requirements. If you and your spouse have separate IRAs, you can't mix those two accounts to draw the total RMD from one account. (Remember that the I in IRA stands for individual – joint IRAs do not exist.) Nor can you mix funds from 401(k) and IRA RMDs to reach a collective RMD total.
- Ignoring Charitable Contributions – One popular – and useful – method of dealing with an excessive RMD is to give some portion of your RMD from a traditional IRA to charity. You can satisfy your RMD requirements by making a Qualified Charitable Distribution (QCD) of up to $100,000 directly from your retirement fund to a suitable 501(c)(3) charitable organization. Such contributions lower your adjusted gross income (AGI) and consequently reduce your tax bill.
If you choose to make a charitable contribution, be sure that the contribution is made directly from the retirement account. Funds that you withdraw are considered taxable income, whether or not you give the funds to charity after withdrawal. Coordinate your contribution with the charity and the fund manager to ensure that the transfer is direct.
- Misunderstanding RMDs for Beneficiaries – Did you inherit an account that requires an RMD? The rules and calculations for RMDs are different for beneficiaries. For example, Roth IRAs are not typically subject to an RMD, but once bequeathed to beneficiaries, they become subject to an RMD. Verify your options with the plan administrator or a financial advisor.
- Poor Account Maintenance – By taking RMD distributions randomly across your portfolio, you miss an opportunity to rebalance your portfolio. RMDs can be targeted to specific investments to reduce an overdependence on equities or bonds, or to remove poorly performing investments.
- Double Taxation – Remember that RMDs relate to pre-tax funds. If you contributed after-tax funds to a traditional IRA – for example, contributing funds from a cashed-out 401(k) – make sure you take that into account when calculating your RMD. Otherwise, you may pay taxes twice on the same funds.
It's possible to rectify some RMD mistakes by requesting a penalty waiver from the IRS. You'll need to fill out Form 5329 and attach an explanation why the full RMD was not taken due to "reasonable error" and that "reasonable steps" are underway to resolve the problem. But why let it get to that stage at all? Plan your RMD strategy in advance – and if you need help, seek the advice of a qualified financial professional.
Regardless of where you plan to retire, the number one factor in ensuring that you can retire on your terms is your 401(k). Make sure that your 401(k) is maximizing its potential with this free analysis that checks your fees, fund mix, and other factors to help you hit your retirement goals.