6 Rules Every Investor Should Know About Retirement RMDs

Ray B. says, "I’ve been a weekly Money Girl listener for many years and appreciate the thoroughness of your podcast. I was reading today that Roth 401k accounts are subject to RMDs while Roth IRAs are not. I thought all Roth accounts were exempt from RMDs, what have I missed?”

Thanks for being a loyal podcast listener and for your question, Ray. RMDs, or required minimum distributions, on retirement accounts can be confusing. If you don’t follow them, either because you don’t want to comply or you just don’t know the rules, the penalty is surprisingly high.  

While RMD rules don’t affect you until later in life, young people should get familiar with them, too. The policies for taking distributions from retirement accounts should be factored into your planning to build wealth, no matter your age.

In this post, I’ll explain what RMDs are and how they affect different types of retirement accounts. You’ll learn six of the most important rules about taking distributions that everyone should know.

6 Important Retirement RMD Rules Investors Should Know

1. Only a Roth IRA has no RMD for the owner.
2. Retirement plans at work have RMD exceptions.
3. Your RMD amount changes every year.
4. Multiple accounts can be subject to different RMD rules.
5. You can use rollovers to your advantage.
6. Not complying with RMDs is expensive.

We’ll review exactly what RMDs are and what you need to know about each of these important rules for retirement accounts.

What Are Required Minimum Distributions (RMDs) for Retirement Accounts?

Required minimum distributions are annual minimum amounts that you typically must withdraw from a retirement account starting the year you reach age 70½. They continue for the rest of your life or until an account is depleted.

The purpose of an RMD is to make sure you eventually pay tax on amounts that weren’t previously taxed. Payouts are subject to your ordinary income tax rate, not the capital gains rate, which gets applied to investment profits outside of retirement accounts.

You can take out more than the minimum, but failing to withdraw what’s required each year results in stiff penalties. There are a few exceptions, which I’ll cover in a moment.

Here’s a summary of six important retirement RMD rules you should know:

1. Only a Roth IRA has no RMD for the owner.

You must take RMDs from traditional, tax-deferred accounts that you own as an individual, a business owner, or through an employer, including a:

• Traditional IRA
• Self-employed plan, such as a SEP-IRA, SIMPLE IRA, and solo 401(k)
• Plan through an employer, such as a 401(k), 403(b), and 457
• Profit sharing plan
• Employee stock ownership plan (ESOP)
• Federal Thrift Savings Plan (TSP)

Additionally, Roth accounts at work, such as a Roth 401(k) or Roth 403(b), are also subject to RMDs. That’s what Ray asked about at the top of this post.

Because you own a Roth at work, the rules require you to take RMDs. However, since you make after-tax contributions to a Roth, withdrawals of contributions and earnings from a workplace Roth or a Roth IRA are always tax-free.

But a Roth IRA is unique because it’s the only account that has no RMD while the original owner is alive. This exception allows you to keep money you don’t need growing tax-free for your heirs. But after your death, beneficiaries who inherit your Roth IRA must comply with RMD rules.

See also: 7 Micro Habits That Create Financial Success

2. Retirement plans at work have RMD exceptions.

If you have a retirement plan at work, such as a 401(k) or 403(b), there’s an important RMD exception to know. If you’re not ready to retire by age 70½ and are still working for an employer where you have a retirement plan, you don’t have to take RMDs.

Whether you need to keep earning income or simply enjoy your job, it’s becoming more common to keep working past age 70½. As long as you don’t own more than 5% of the company where you work, you can generally delay the requirement to take distributions from a traditional or Roth workplace plan until you finally retire.

In some cases, the rules may allow you to still be considered employed for the purposes of this exception, even if you’re working part time. Check with your retirement plan administrator to understand what’s allowed.

Also note that the still-working exception doesn’t apply to any other type of retirement plan for individuals or the self-employed, such as a traditional IRA or a solo 401(k), or retirement accounts you have with previous employers.

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3. Your RMD amount changes every year.

The most confusing part of the RMD rules is how the amount is calculated. Your annual required withdrawal is based on the balance in your account at the end of the previous year and on your longevity.

The IRS publishes several life expectancy tables in Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), based on your situation. There’s a table if your beneficiary is a spouse who is at least 10 years younger than you, one if your spouse isn’t as young, and one if you inherited a retirement account.

The tables give you a different life expectancy factor every year. You take the account balance as of December 31 of the previous year and divide it by your life expectancy factor from the appropriate IRS table. The result is how much you must withdraw for the current year.

For example, let’s say you’re 70½, have $400,000 in a traditional IRA, and have a life expectancy factor of 27.4. This year you’d need to withdraw $14,599 ($400,000 divided by 27.4). As I’ve mentioned, you can withdraw more, but you can’t apply an excess toward the RMD requirement for future years.

Your retirement account custodian typically lets you know the amount of your RMD and sends out Form 1099-R to report the distribution. Setting up an automatic monthly or quarterly RMD withdrawal plan can help you stick to a budget.

See also: 6 Essential Habits of Financially Healthy People

Bonus Tip from The Penny Hoarder

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1. The 50/20/30 Method. Break down your income and split your spending into three categories: 50% goes to essential bills and expenses, 20% toward financial goals, and 30% to personal spending (all the stuff you like to spend money on but don’t really need).
2. The Envelope Method. So-called envelope budgeting is traditionally a cash-only budget. Every month, you use cash for different categories of spending, and you keep that cash for each category in separate envelopes — labeled for groceries, housing, phone, etc.
3. The Zero-Based Budget. The way you draw up this budget, your income minus your expenses (including savings) equals zero. This way, you have to justify every expense.

For more tips, visit The Penny Hoarder. 

4. Multiple accounts can be subject to different RMD rules.

The RMD rules vary a bit if you have multiple retirement accounts. If you have more than one 401(k), you must calculate and withdraw your RMD separately from each of them.

However, if you have multiple IRAs, you can figure the RMD for each account and add them to determine your aggregate RMD. For this rule, you can include all types of IRAs, including traditional IRAs, SEP-IRAs, and SIMPLE IRAs.

Once you know your aggregate IRA amount, you can take it from your IRAs in any ratio that you want by the end of the year. For instance, you could take the aggregate total from just one IRA until it’s depleted and then draw down the next IRA. Or you could split up the total by taking it from multiple IRAs in the same year.

Interestingly, this aggregation rule also applies when you have more than one 403(b) plan. You can combine RMDs and take the total from one or more of your 403(b)s in any proportion you like.

But you can’t aggregate 401(k)s or 457 plans, nor can you combine different types of retirement accounts, such as an IRA and a 403(b) into one RMD.

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5. You can use rollovers to your advantage.

One way that Ray could avoid having to take future RMDs from a Roth 401(k) is by doing a rollover to a Roth IRA. As I mentioned, it’s the only retirement account that doesn’t require the original owner to take RMDs. Doing a tax-free rollover to a Roth IRA would give you the ultimate flexibility for taking withdrawals as you wish and allowing your heirs to benefit from tax-free distributions.

Just to be clear, you can’t take an RMD from one retirement account and roll it over to another retirement account in an effort to avoid taxes.

However, you can take an RMD from a 401(k), pay taxes on it, and then deposit it into a Roth IRA as a contribution. (You can’t make traditional IRA contributions after age 70½). But you must have earned income that doesn’t exceed the annual Roth IRA income limits to be eligible to make contributions.

Whether you can even do an in-service rollover before leaving your employer depends on the fine print of your retirement plan. Ask your benefits administrator what’s possible.

Likewise, if you’ve reached the age of 70½ and qualify for the still-working exception that I previously mentioned, you might consider a reverse rollover to delay RMDs from a traditional IRA. Most employer plans accept rollovers from IRAs and from 401(k)s of your previous employers.

Again, check with your human resources department or the workplace plan’s custodian to see if a reverse rollover is possible. If so, it could be an effective way to delay RMDs when you’re still working and don’t need the income or additional tax burden.

6. Not complying with RMDs is expensive.

Many investors begin taking distributions from their nest egg when they start taking Social Security retirement benefits, which can be before age 70. You can make penalty-free withdrawals from any type of retirement account after you reach age 59½.

But if you haven’t started tapping retirement savings in your 60s, you must take RMDs after you turn 70½ whether you need the money or not—so don’t forget the deadline to comply.

Your first RMD must be taken by December 31 of the year you turn 70½, or by April 1 of the following year. This is a one-time extension given to first-timers. If you use it, you must also take your second withdrawal by December 31 of the same year, which means you’ll have an oversized tax bill.

As I mentioned, you can always withdraw more than the minimum required amount. But if you miss the deadline or withdraw too little, you must pay income tax, plus an additional 50% penalty, on the amount you failed to withdraw.

What If You Don’t Need Funds from an RMD?

If you’re fortunate enough not to need the funds you receive from an RMD, there’s plenty you can do with it. One option is to reinvest it in a regular, taxable brokerage account or to keep it in a bank savings or CD. Or you might spend your hard-earned money on a treat, such as a family vacation or a new vehicle.

If you’re in the giving mood, you could use funds from an RMD to pay for a child or grandchild’s education. If you contribute it to a 529 college savings plan you may qualify for state income tax deduction, depending on where you live.

Charities would love to receive your RMD as a qualified charitable distribution (QCD). A QCD is a nontaxable distribution up to $100,000 (or $200,000 if you file a joint tax return), paid from your IRA directly to a qualified charity. If you’re in a position where you must take RMD money that you don’t need to spend, consider using it to make a difference in the lives of family, friends, or even total strangers.

To learn more about retirement accounts and the best places to open them, the Retirement Account Comparison Chart is a free, one-page resource that you may find helpful.

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