Written by Hi, it’s Dre Griggs with Obsidian Wisdom. Today, we answer the question: What is the required minimum distribution (RMD) and how are they taxed?
What is a Required Minimum Distribution (RMD)?
Today, we’re going to discuss a pretty important topic for retirees, and that is the required minimum distribution. We’ll cover three important aspects:
- What are RMDs?
- How are they calculated?
- How are they taxed?
We’ll have a bonus discussion at the end where we’ll also discuss ways for you to minimize your RMDs so you can limit how much Uncle Sam is taking from you in taxes. At the end of the day, we did not work this hard for Uncle Sam to take our money and just build a random bridge to nowhere. So today, we’re going to discuss ways for you to keep as much of this money as you can inside your own family’s legacy and not in Uncle Sam’s.
Because many of you said you enjoyed the case study and it made the complexities of tax planning and Social Security a little bit easier to digest, I’m going to go ahead and do another case study today where we’ll go into that a little bit later. But let’s start with what simply is a required minimum distribution.
What Are RMDs?
At the end of the day, RMDs are money that you put in a pre-taxed account. When I say pre-taxed, that means money that simply hasn’t been taxed yet. And because it has not been taxed yet, Uncle Sam is itching to get some of his money. When he’s looking at your money in your 401(k)s, your 403(b)s, and other pre-tax retirement accounts, he’s thinking, “I don’t want this person to pass all of their wealth on to the next generation and then maybe to the next generation and the next generation.” Uncle Sam is like, “What if I never get to spend this money? It’s just growing in this account.” So, the government came up with an amazing idea: required minimum distributions.
RMDs are just as they sound: money that you’re required to take out of your pre-tax retirement accounts. You and I would sit there and say, “Well, what if I don’t need the money?” Uncle Sam would say, “Too bad. You need to take the money out of the account. If you don’t, I will penalize you a percentage of the amount of money that you were supposed to have taken out.” And you would say, “Well, what if I just didn’t know what the right amount was?” Uncle Sam would say, “Too bad. I’m going to penalize you a percentage of the amount that you were supposed to take out.”
So now you’re sitting there saying if I have to choose between taking the money out and spending it on something that maybe I wasn’t super interested in spending it on, or Uncle Sam is going to penalize me and I don’t spend any of that money—it’s just simply taken from me and given to Uncle Sam as tax revenue—I’m going to spend the money while it’s in my control on things that benefit me.
How to Calculate RMDs
All right, so, you see on the screen, we have Lamar and Sophia. Lamar is 75 years old. He is a retired financial analyst. Sophia is 69. She is a retired pharmacist. They’re still hanging out here in good old Florida. Their combined retirement income savings is $2.3 million. Their Social Security is $25,000 and $30,000, so they have $55,000 in Social Security.
When you’re looking at calculating your RMDs, let’s go ahead and calculate it for Lamar because he is over 73. When you’re talking about RMDs, it used to be 70.5. Then it went up to 72 with the Secure Act of 2019. After COVID, they raised it up to 73. So that’s where it’s at now. At 73 years of age, you are required to start looking at your RMD.
Now, I know some of you are saying, “Dre, are you sure that I have to take it? Are there no exceptions?” Of course, there’s always exceptions. If you’re past age 73 and you’re still working and you don’t own 5 percent of that company, then you can continue working without taking any RMDs until the year after you retire. So if you’re turning 80 years old this year, then next year you would have your first RMD.
RMD Exceptions
For Lamar, he’s already retired. So, we don’t have to really have that discussion. Lamar is 75 years old. To calculate, you have to determine how much money is in an account that hasn’t been taxed. That is a pre-tax account that Uncle Sam would require you to take money out of. If the money is inside a Roth account, it’s already been taxed, so you don’t have to worry about that. If the money is in real estate or the regular stock market (your brokerage account), that is not a pre-tax account, so it doesn’t have an RMD. Inside Lamar’s plan, he only has $500,000 of that $2.3 million that’s inside his IRA. That money is subject to the RMD.
You then divide that number by your life expectancy factor. There are two tables that the IRS gives us. The majority of us will use the IRS Uniform Lifetime Table. There is a second table, which I’ll show you both of them, but if you’re looking at the Uniform Lifetime Table, Lamar’s factor is 24.6. Now you may be sitting there saying, “Well, Dre, how did you get that number?” I’m glad you asked.
IRS Tables
You can see here on the IRS website, this is Table 3: the Uniform Lifetime Table. You take whatever amount you have that is subject to the RMD and divide it by your factor. This table is for unmarried owners or married owners whose spouses aren’t more than 10 years younger, and for married owners whose spouses aren’t the sole beneficiaries of the IRS. So again, this is going to be for the majority of people. At 75 years of age, Lamar’s distribution period factor is 24.6.
As you can see, the older we get, the smaller the number becomes. Because the number of the denominator being smaller means it’s a larger number that we end up with. So the longer we live, the smaller the number is, which means the more we’re required to take out, even if we don’t necessarily have any plans for it.
Now, at the end of this video, I will go over some strategies to help you reduce your RMDs so that you don’t have to pay a whole bunch of taxes and worry about these penalties, but it’s important to note that. Now, the second table is the Joint Life and Last Survivor Expectancy Table. This is for owners whose spouses are more than 10 years younger than them and are the sole beneficiaries of their IRAs. If your spouse is over 10 years younger than you, and if you have them as the sole beneficiary of your IRA (meaning the money is not coming to you while you’re alive), then you use this table to calculate it. The number across the top is your age. The number across the bottom is your spouse’s age.
Calculating Your RMD
To calculate your RMD, you would take your account balance on December 31st, which we said was $500,000, and divide it by 24.6 (Lamar’s factor). That gives us about $20,325. That’s what our RMD is, and we would have to spend that amount out of our IRA to make sure we’re not penalized by the IRS.
Now, it’s important to remind you that we’re talking about the total amount of money you have in these pre-tax accounts. You have $500,000 in an IRA, $100,000 in an old 401(k), money in a TSA, or a 403(b). We’re talking about adding up the balances in all of these accounts and then dividing that total number by your overall factor. This is something a lot of people sometimes mess up, so it’s important to make sure we’re on the same page.
In this case study, we know that we’re supposed to take out $20,325 over the course of this year. For some reason, if we don’t take that amount out, we have a penalty. Now, that penalty was reduced in 2023. It used to be 50%, which is a pretty steep penalty. If we were supposed to take out $20,325, we would have had a penalty of $10,117.50. That would have been the 50% penalty for not taking that amount out.
In 2023, the government reduced that penalty amount to 25%. They added a further reduction where the penalty is 10 percent as long as you do it promptly. Most people consider promptly to be within two years. If you notice that you did not take out the right amount as far as your RMD and you go into your retirement accounts and withdraw that extra amount, then your penalty would only be 10 percent.
Penalty Examples
For example, if Lamar was supposed to withdraw $20,325 in RMD and he withdrew none of it, he will pay a 25% penalty on the amount he was supposed to withdraw, totaling $5,081.25.
If Lamar realizes within two years that he didn’t take his RMD and promptly withdraws the $20,325, his penalty would be reduced to 10%, resulting in a penalty of $2,032.50.
If Lamar withdrew 50% of what he needed to take, instead of $20,325, he only withdrew $10,162.50. The penalty is then 25 percent on the amount he was supposed to
take out but didn’t. In this situation, $10,162.50 multiplied by 25% is $2,540.63.
How Required Minimum Distributions are Taxed
When it comes to discussing how your RMDs are going to be taxed, they’re taxed as normal income. Any amount you have inside your pre-tax account means the money has not been taxed yet. You received a tax deduction on that amount when you placed it inside your 401(k), 403(b), and other pre-tax accounts. When you take the money out because it has not been taxed yet, Uncle Sam is going to tax it at your normal income tax rate.
Strategies for Managing Your RMDs
Timing Withdrawals
Once you reach 59 1/2, if you’re concerned about having huge RMDs, you can start taking money from these pre-tax accounts to avoid large required withdrawals at 73. For example, if you have $500,000 inside your 401(k) or IRA, you can start taking money out to prevent a large percentage withdrawal requirement at 73 years of age.
Converting to a Roth Account
Another strategy is converting a percentage of your pre-tax accounts to a Roth IRA. The money inside your Roth IRA grows tax-free, and you can withdraw it tax-free. You pay taxes on the conversion, so any year you’re in a lower tax bracket, convert enough to bring you to that tax bracket. This might be $100,000 in one year or $50,000 in another year. Continue these conversions each year to ensure that by the time you retire and face RMDs, you have little to no money in pre-tax accounts.
Qualified Charitable Distribution
Once you reach 70.5, you can take up to $105,000 and give it to a 501(c)(3) nonprofit. They don’t pay taxes on it, and it counts as your RMD for the year. This way, you don’t pay taxes on that amount either.
Final Thoughts
When it comes to RMDs, having a plan in place that gives you more time is beneficial. If you have five or ten years to limit the amount of money you’ll pay in taxes, you can start moving money each year and pay a portion of taxes annually. By the time you’re 73, you might have little to nothing in your pre-tax account, avoiding large RMDs.
If you’re nearing retirement and have questions about putting a proper plan in place, you can always visit ObsidianWisdom.com/Wealthy to learn more. Until next time, stay safe and enjoy life.
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