Traditional retirement accounts are tax-deferred, not tax-free. As baby boomers turn 70, they must soon begin mandated withdrawals and pay the taxes on the money they tucked into retirement accounts over several decades.
A required minimum distribution is the amount retirement account owners must withdraw from their IRAs and 401(k)s each year. When you take these withdrawals, you also have to pay taxes on each distribution. Retirement account withdrawals are required after age 70 1/2, except for Roth IRAs, which do not have distribution requirements for the original account owner.
It can be somewhat complicated to calculate your required minimum distribution, especially if you have multiple retirement accounts. If you miss a distribution or withdraw the incorrect amount, you could trigger big tax penalties. "There are tax consequences once you reach the point of taking RMDs," says Jared Snider, a senior wealth advisor at Exencial Wealth Advisors in Oklahoma City. "The biggest mistakes all relate to taxes."
Required minimum distribution mistakes include:
-- Forgetting a RMD.
-- Failing to consult a financial professional.
-- Making no long-term plan for required withdrawals.
-- Not realizing that distributions count as income.
-- Missing a RMD deadline.
-- Withdrawing the wrong amount.
-- Assuming 401(k)s and IRAs have the same RMD rules.
Here's how to prevent some of the most common required minimum distribution errors.
Forgetting a RMD
The penalty for missing a required distribution is 50% of the amount that should have been withdrawn in addition to the income tax due. However, only 38% of Americans are aware that they have to take a RMD, according to a 2019 TD Ameritrade survey. "As baby boomers are hitting RMD age, they need to be aware that they need to take a RMD," says Dara Luber, senior manager of retirement at TD Ameritrade. "It's likely they are not being educated, or not thinking about retirement or just thinking about the fun things. They are not necessarily focusing on financial needs and planning."
Failing to Consult a Financial Professional
Required minimum distributions are calculated by dividing your retirement account balance by an IRS estimate of your life expectancy, or perhaps the life expectancy of you and your spouse. Some people need assistance determining their distribution amount. "If you don't calculate or you don't calculate correctly, the penalty is 50% (of the RMD)," says Kelly Famiglietta, vice president and partner of retirement plan services at Charles Stephen in Albuquerque, New Mexico. "If you have access to an advisor, that's the best thing. Get some help."
Making No Long-Term Plan for Required Withdrawals
RMDs are considered taxable income and can have a big impact on your annual tax bill. Some advance planning can help you minimize taxes on your required withdrawals. "Failure to plan can lead to a variety of errors when it comes to taxes and income," Snider says. "You may have more income than you want to show up on your tax returns." If there is no plan, and you have income from other sources, the RMD can push you into a higher tax bracket, which will result in a more expensive tax bill.
Not Realizing That Distributions Count as Income
By increasing your taxable income, the distribution can not only push you into a higher tax bracket, but it can also affect other types of retirement benefits. A required minimum distribution could impact your Medicare premiums, which are based on your income, whether your Social Security payments are taxed and your child's eligibility for financial aid for college. "If you don't need to take more out, don't," Famiglietta says.
Missing a RMD Deadline
Your first required minimum distribution is due by April 1 of the year after you turn age 70 1/2. But after that, each subsequent RMD is due by Dec. 31. That could mean you have to take two RMDs in the same year, which might result in additional costs. You could be bumped to a higher tax bracket, your Medicare costs could increase and your Social Security benefits could be taxed. "You need to think it through," Luber says. Some financial advisers recommend taking your first distribution by Dec. 31 in order to avoid two distributions in the same year.
Withdrawing the Wrong Amount
While there are many RMD calculators, Luber suggests using an IRS calculator. Make sure that you are determining the RMD using the account balance on Dec. 31 of the previous year. The correct amount is based on your age, account balance and life expectancy.
Assuming 401(k)s and IRAs Have the Same RMD Rules
The withdrawal rules are different for IRAs and 401(k)s. If you have multiple IRAs, you have to calculate the RMD for each account separately. However, you can aggregate and take your total RMD from just one IRA. The rules are different for 401(k)s, and you have to take a RMD from each 401(k) account. Also, spouses cannot aggregate between their accounts. Each spouse has to withdraw money from his or her own retirement account.