There is no shortage of acronyms when it comes to finances. One you may be hearing in the news lately is RMD, or Required Minimum Distribution. A client recently asked me to explain this concept in more detail.

So, let’s take a look at what an RMD is, how it may apply to you (now or in the future), and what changes are currently in the legislative que.

What is an RMD?

The term essentially defines itself – a RMD is a calculated amount (based on your age and account balance) that is required (by law) to be taken from your pre-tax retirement account(s) once you reach the starting age. Why would the government put such a rule in place? Again, RMDs only apply to pre-tax retirement accounts (*see strange exception below related to Roth 401ks).

Any funds in those pre-tax accounts have not yet been subjected to income tax (you received a deduction upon their contribution, or they were deposited by your employer who received a deduction). If you didn’t need these funds, without an RMD, you could defer that tax in perpetuity. With an RMD, the government starts the clock on your distributions – and resulting taxation

What accounts are subject to RMDs again?

They cover all tax deferred retirement accounts, including:

• 401(k), 403(b), and similar workplace retirement plans
• SEP IRAs
• SIMPLE IRAs
• Traditional IRAs

The regulations also require RMDs to be taken from Roth 401(k) accounts, which is a common point of confusion as funds in a Roth IRA are not subject. (You can always consider rolling your Roth 401k funds into a Roth IRA to avoid this – definately something to watch out for)

How do I calculate my RMD?

You need two pieces of information – your year end balances (of the tax deferred accounts and Roth 401k) – and your distribution period (which is obtained from the IRS guidelines and is based on your age). You divide the balance by the distribution period and that is your RMD for that year

Note: the distribution periods were just increased this year to acknowledge that longevity is improving. The IRS has yet to make them readily accessible on their website, but you can view them here

Most custodians will calculate your RMD for you, on each individual account. However, it’s best practice to validate that calculation.

In addition, if you have accounts at various custodians, you will need to ensure that they are all accounted for and that your full RMD is processed. As a result, it can be helpful to consolidate your accounts at one custodian as you approach RMD age

When do I have to take my RMD by?

The RMD requirement starts in the year in which you turn 72. In the first year, you have until April 1 of the year following the year of your 72nd birthday. However, for each subsequent year, the RMD must be taken by December 31. As a result, many people choose to take their first one in the year of their 72nd birthday to avoid “doubling up” for tax purposes

What happens if I take too little or too much?

If you miss a deadline or don’t withdraw your full RMD, the penalty is stiff: 50% of the amount you failed to withdraw. For example, if your RMD was $100,000 but you withdrew only $50,000, you’d owe half the shortfall ($25,000) as a penalty.

It’s a minimum distribution, so you are free to take more than your RMD amount in any given year. However, as noted in the next section, don’t forget about tax implications

What else should I watch out for?

This can be a complicated process – from both a logistics perspective, as well as a tax/financial perspective.

As noted above, you must ensure you are capturing all pre-tax accounts. If you have things consolidated and organized, that won’t be an issue. But if you have lingering employer plans at various custodians or an annuity, this could become an issue.

In addition, there are rules surrounding which accounts the RMDs can come from (ie: you can group multiple IRA RMDs into one IRA withdrawal, but an employer plan RMD (ie: 401k) must be taken from that account directly, not an IRA).

You also need to consider the impact that RMDs will have on your taxable income and resulting tax status and other items tied into income (such as Medicare premiums and taxation of social security). If your RMDs will be sizeable, you may wish to start distributions sooner (age 59.5 is when excise penalties are no longer in play) to spread the income over more years. You can also consider other strategies, including Roth conversions and Qualified Charitable Distributions – both of which are rather complex and deserve their own article!

As you can see, RMDs are not as simple as they may sound, so as always, we suggest careful coordination with your tax and financial advisor

What’s the pending legislation about?

Secure Act 2.0 is presently in front of the Senate. Among other things, the legislation increased the starting age for RMDs from 72 to 75. The Senate version of the bill also modifies RMD rules to exempt certain annuity benefits and payments from the minimum income threshold test and updates the mortality tables to reflect longer life expectancies.

Nothing has been passed yet – but changes could be coming

Note: All commentary above is as of the date of this post and is for education and informational purposes only. Windermere and its principals do not intend for this to serve as investment advice and are not responsible for any actions taken based on this article. Consult your financial advisor before taking any actions as it relates to your own investment portfolio