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A-Z Guide on Calculating Required Minimum Distributions

Traditional IRAs (Individual Retirement Accounts) and other employer-sponsored retirement savings plans like a 401(k) account, etc., allow you to contribute a specific sum, which is exempt from federal taxes for a specific time, sometimes nearly for decades. However, you cannot keep your money in these accounts indefinitely. The IRS (Internal Revenue Services) mandates you to start making withdrawals from your IRA, 401(k), etc., by the age of 70.5. These mandatory drawings are known as required minimum distributions (RMDs). As of 2020, the withdrawal age from retirement accounts has been changed to 72 to avoid any tax charges and penalties post this age. However, the RMDs from retirement accounts for 2020 have been suspended by the government to extend support to investors by allowing their funds more time to recover from the year’s stock market slump. That said, generally, the RMD amount for each subsequent year is based on a set criteria for RMD calculation.

What are RMDs?

RMDs are minimum withdrawals that you must take from your retirement savings account each year once you reach the age of 72. RMD rules apply to the below retirement savings accounts:

  • Traditional IRAs
  • Nearly all 401(k), 457(b), and 403(b) accounts
  • Rollover IRAs
  • SIMPLE IRAs
  • SEP IRAs
  • Most small business accounts
  • Other defined contribution plans
  • Profit-sharing plans

You can also take more than your RMD in a specific year. The money you take out annually will be considered a part of your taxable income for that year, excluding any portion of the money, which has already been taxed before. Also, in case the withdrawals are qualified and are designated tax-free by the IRS, you would not be charged any tax on them.

The deadline to take RMDs from your accounts is December 31st each year. However, in the case of an IRA, you can delay your first distribution until April 1st of the year in which you turn 72. That said, in case you choose to delay your RMD, you will need to withdraw your first and second RMD in the same year of taxation.

What is the purpose of an RMD?

The main objective of an RMD is to safeguard the retirement accounts from investors who are investing solely for the purpose of avoiding tax penalties.

What are the penalties on RMDs?

In case you miss taking your mandatory distribution by December 31st of each year after turning 72, the IRS will levy a strict penalty. The penalty charge could be 50% of the sum not taken out on time. The penalty is charged irrespective of the retirement savings account.

How to calculate RMDs?

Typically, RMDs for a year are determined based on a specific formula. It involves dividing the total account balance (as of the end of the preceding calendar year) of your retirement savings account by the applicable distribution period based on the IRS calendar. The applicable distribution period table, known as IRS Uniform Lifetime Table, typically depicts your life expectancy factor against your age, as on your birthday of the current year.

However, if your spouse is the sole beneficiary of your account or if your spouse is ten or more years younger than you, the life expectancy component is derived from the IRS Joint Life Expectancy Table. This table assigns a life expectancy factor corresponding to your and your spouse’s age as on your birthday of the current year.

RMD calculation in the first case:

For instance, Mr. X, who is married and is turning 72 this year, has $100,000 in his IRA account balance as of December 31st last year. His wife is of the same age. Hence, he is choosing the IRS Uniform Lifetime Table to calculate his RMD for the current year.

In this scenario, the applicable life expectancy factor as per the IRS Uniform Lifetime Table is 25.6.

So, Mr. X would need to take out $3,906.25 annually from his IRA account ($100,000/25.6 = 3,906.25)

This formula can be used for any other account mentioned above.

RMD calculation in the second case:

For instance, Mr. Y, who is married and is turning 75 this year, has $100,000 in his IRA account balance as of December 31st last year. His wife is 62 and is the sole beneficiary of the account. Hence, their age gap is more than ten years. So, he chooses the IRS Joint Life Expectancy Table to calculate his RMD for the current year.

In this scenario, the applicable life expectancy factor as per the IRS Joint Life Expectancy Table is 25.

So, Mr. Y would need to take out $4,000 annually from his IRA account ($100,000/25 = $4,000)

This formula can be used for any other account mentioned above.

Some points to bear in mind:

Ideally, the custodian of your specific retirement account or the administrator of the plan will calculate your RMD and report it to the IRS. However, it is always advisable to stay informed about your withdrawal mandates and deadlines so that you do not pay any penalties.

Some things to take note of while calculating your RMD are:

  • Under specific conditions, some qualified plans allow you to delay the beginning of your RMDs until you retire. This grant is applicable even if you are older than 72. However, you need to check with your employer or plan administrator if you are qualified for this criterion.
  • You can withdraw more than the specified amount of RMD. You can also take 100% of your contributions in the first year but would need to pay a hefty tax bill on the same.
  • When calculating your RMD in a year, always check the IRS website for the latest information and calculation worksheets.
  • Always be sure that you are using the correct calculation table as per your financial situation and account rules.
  • For each account type that has an RMD rule, you would need to calculate your RMD separately. This is also applicable in case you own multiple IRAs. In this case, you will calculate the RMD separately for all IRA accounts.
  • You can either choose to take your RMD in a lump sum figure or opt to take it in increments across the year. However, in totality, you should take out the specified amount before December 31 of each year.
  • That said, in the special case of an inherited IRA, you are required to take annual distributions irrespective of your age. If you fail to make the specified withdrawals, the IRS can levy a 50% tax penalty on the RMD figure. However, spouses and non-spouses have different rules in such cases. Hence, you should check the IRS guidelines in relation to inherited IRAs.

To sum it up

Calculating RMDs is fairly easy with the easy accessibility of information online. However, the situation can get slightly complex in different financial situations, concerning the spouse or even in the case of multiple retirement savings accounts. Therefore, may be advisable to consult a professional financial advisor to help you make the right RMD calculation in complex scenarios.

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