Does a 25% or 50% penalty seem steep to you? It certainly does to me, so let’s make sure we understand RMDs and don’t let this happen to you!
RMD or Required Minimum Distribution is the term associated with Individual Retirement Accounts (IRAs) and 401(k)s in the United States. The IRS allowed tax breaks and the ability to let these accounts compound faster by not paying taxes as you went along in life… eventually they come calling for their share (Ha Ha). An RMD represents the minimum amount an individual must withdraw from his or her retirement account(s) once a certain age is met (currently that age is 73) to ensure the government receives its share of taxes after the assets have been tax-sheltered through the life of the investment.
Once you as an investor reach the age for required minimum distribution, there is not a way for you to avoid this distribution. A percentage of the assets (usually between 3.5%-8% depending on age) must be removed from the retirement account, triggering a taxable event that is reported on a 1099R. However, there are ways to reduce the tax implication as well as ensure no penalties are assessed. The goal: always being preservation of your investment while sending as little as legally possible to the IRS. Nobody likes to pay taxes!
The IRS for many years has imposed up to a 50% penalty on the amount of RMD not taken within the correct calendar year – OUCH! For example: if you are subject to an RMD of $1000 but only withdrew $600 for the year: The IRS could assess a 50% penalty on the amount not distributed: $400. This would result in a $200 penalty. Recently the Secure Act 2.0 has allowed for a decreased penalty of 25% or as low as even 10% if you file the appropriate additional tax forms and work quickly to make the expected withdrawal.
Even though there is not any way to avoid taking an RMD from traditional retirement accounts there are options to defer, decrease or help offset the amount subject to taxation. An individual investor could consider the following: Delayed Retirement, Roth Conversion, and or Charitable Contribution.
If you consider Delayed Retirement, you can still contribute to retirement accounts if you have earned income after the age of 73. Each account type has different benefits. If you decide to contribute to a traditional retirement account, the RMD is still expected to be withdrawn, but your simultaneous contributions to the IRA could help lower your income and offset the tax implications of the RMD. Additionally, if you are still working for an employer that offers a 401k: when you reach your RMD age, you may be able to defer taking distributions from you 401k until you retire. Those rules can be complicated and differ from plan to plan. It is highly recommended to check with your 401k resources at work and or your CPA. The next option to lessen tax implication is to have the retirement investment held in a Roth account.
Holding retirement assets in a Roth from initial investment or opting for a Roth conversion(s) later in your investment journey is another option to decreasing the tax implication and requirement to take an RMD. One of the ways a Roth account differs from a traditional retirement account is that the assets are taxed at the time of contribution but if held long enough (over 5 years) and until you reach a specific age (59 ½) before starting to redeem: then all the earnings are tax exempt. Why is this good? …a few reasons (1) You pay taxes up front on the original contribution or conversion amount and all the earnings and growth become tax free many years down the road. (2) You don’t have to take an RMD on Roth IRAs, which could lead you to pass along more money to your children or heirs if that was an important goal.
Are you charitably inclined? The last way to lessen the tax implication is by donating the required minimum distribution amount. You can work with a financial institution to send your RMD directly to a qualified charity of your choice and eliminate the tax burden the RMD would normally cause.
Maybe you’re thinking “I’ll take the RMD, pay the tax required, but I don’t really need the money to live on and I would like to keep it invested for the long term.” If that is the case, you can take the required minimum distribution which triggers a taxable event (The IRS is now happy) and then deposit the distributed assets into a non-retirement investment account. This can ensure your money is still working for you instead of sitting in cash.
Hopefully you now have a better understanding of RMDs and how to avoid those costly penalties and potentially lower the taxes you pay to the IRS. Every person’s tax situation can be complicated and unique to them, so please check with a tax or financial professional before implementing any of these options or strategies.