Investor Facts: What Is A Required Minimum Distribution?

A required minimum distribution (RMD) is an annual taxable withdrawal from your retirement savings dictated by IRS regulation.

When you open an individual retirement account (IRA), the money you place there is free of income tax in the year you save it. The growth and income on that investment is untaxed, too.

However, upon reaching age 70½ the government will require you to take a specific percentage amount of that money out (a distribution) and continue to do so every year. Taxes are due at your regular income tax rate on those annual withdrawals.

It’s important to consider how a required minimum distribution will affect your income and spending in retirement. Your Social Security income will be taxable, and you will have to take required minimum distributions on your 401(k) or 403(b) retirement savings accounts as well, either at 70½ or the date you retire.

Tax planning in retirement can be tricky. Many people continue to work, which means they generate taxable income even after “retiring” from their long-term career. Some folks take income from Social Security and income from a taxable pension, too.

As a result, new retirees sometimes find that working pushes them into a higher tax bracket. In addition, whether all or any of your income is taxable at the state level is a matter of where you choose to live.

The best of all worlds is to have too much income and nothing to do with it. Yet nobody wants to pay too much in taxes either. That’s why a Roth IRA can be a useful tool for reducing your tax burden in retirement.

Converting to a Roth IRA is not cheap; you owe taxes on the money you convert that year on top of your normal income tax. Yet the money in that Roth IRA now grows tax-free and is not subject to a required minimum distribution, although there are withdrawal rules to understand.

Lowering the impact of RMDs

The IRS uses an actuarial table to calculate how much you will be forced to take out as a required minimum distribution each year. In essence, it’s your account balance divided by a “life expectancy factor” published by the IRS.

It might be a small amount early on, but if your account grows dramatically in value as you age RMDs naturally become larger. Failing to take out the required withdrawal amount results in a stiff penalty — half the money (50%) rather than your actual tax bracket rate.

Nevertheless, you can offset the impact of a required minimum distribution by making charitable contributions with the money instead or through tax-free gifts to your family. Any legitimate way to reduce your income will lower the impact of RMDs in retirement.

Always consult a CPA or qualified tax advisor before taking action. Laws can change and your tax situation can be affected by many factors.