Nearing Retirement? Take IRA/401k Withdrawals or Pay a 50% Penalty
If retirement is drawing near and you’ve been putting money into a tax-advantaged IRA or 401k, you probably have a decent sized nest egg by now. You also know that withdrawing money before the age of 59½ means you’re liable both for taxes and a 10% early withdrawal penalty.
As you get older, though, another mistake could make an even larger dent in your retirement savings – NOT taking money out of them. After the age of 70½, most tax-deferred retirement plans have Required Minimum Distributions (RMDs), with a 50% tax penalty for non-compliance!
7 RMD Facts to Keep in Mind
If you’re turning 70½, here are 7 essential things you need to know about RMDs:
- Calculation – RMDs are calculated according to your age and the account value on the last calendar day (Dec 31st) of the previous year. As such, the amount is different for each account, and it changes as you get older.
- Penalties – RMD penalties are among the heaviest, at 50% of the amount you were supposed to take by the deadline. If you take less than the minimum, the penalty of 50% will be applied to the balance that you didn’t take.
- Deadline – You need to take RMDs by the last calendar day (Dec 31st) of the tax year. If you miss the deadline or don’t take the complete amount due, you will be liable for the 50% penalty.
- Taxes – RMDs will be treated as taxable income for the year when you take them, and will be added to your total income. You may be liable for income tax, depending on the tax bracket you fall under.
- Social Security – Since RMDs are treated as ordinary income, they could take your income over the threshold for Social Security. As a result, 50% or 85% of your benefits may become taxable.
- Exceptions – The only exception applies to money invested in a Roth IRA. These accounts have no RMD during your lifetime, but your beneficiaries will be subject to the 50% penalty if they don’t take RMDs after your demise.
- Postponement – You can postpone the first RMD due after you turn 70½, but only until April 1st of the following year. You will then have to take a second RMD in the same tax year, before the Dec 31st
Your IRA provider may be able to calculate the annual RMD and automatically transfer that amount to your savings account or another retirement fund, but you should keep track of them as well.
Including RMDs in Your Personal Finance Strategy
If you’ve invested in tax-advantaged retirement plans (other than Roth IRAs), you can start taking distributions after the age of 59½. You can choose to let the money grow, but after the age of 70½, it’s mandatory to take a minimum amount every year.
RMDs for each tax year are calculated by the IRS, using a formula that takes your life expectancy and account balance into consideration. The amount will be different for each tax-deferred account you own, and you can use IRS worksheets or online calculators to estimate how much this will be.
3 Ways to Avoid/Minimize Your RMDs
Here are three options for reducing or avoiding RMDs on your tax-deferred retirement savings:
- Roth IRAs – Roth IRAs are funded with post-tax contributions and have no RMDs, so convert all or part of your traditional IRA or 401k savings into one. This is especially helpful if your retirement income is low, you’re under 70½, and have not yet claimed Social Security benefits.
- QLAC Annuities – Using your RMD to buy a Qualifying Longevity Annuity Contract (QLAC) protects your retirement income and reduces your RMDs. It’s tax-free, if you use 25% of your total assets in retirement accounts or $125,000, whichever is lower, and start taking distributions after the age of 85.
- Charity – With a Qualified Charitable Distribution (QCD), your annual RMDs can be gifted directly to a qualified charity of your choice. If you already donate to a charitable institution or trust, this is a great way to maximize the tax deductions on your IRA or 401k proceeds.
Many people use the outdated “4% rule” to decide how much they should take as distribution every year. However, you’re better off following RMD guidelines provided by the IRS or consulting a personal finance advisor to understand how withdrawals will affect your Social Security benefits and tax deductions.
* Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He regularly writes for blogs at MoneyForLunch, Biggerpocket, SocialMediaToday, NuWireInvestor & his own blog for Self Directed Retirement Plans. You can learn more about Rick at www.sdretirementplans.com.
*Note: This is a guest post from Rick Pendykoski. Rick is not affiliated with Eagle Financial Solutions, and this information is provided for ecucational purposes only, and should not be considered as financial advice.