This is a good news, bad news story about your retirement accounts. The bad news is it’s complicated, and recent changes to RMD rules have added complexity. The good news is that your money can grow on a tax-deferred basis for a longer period before you have to start withdrawing it and paying taxes on those savings.

In a bid to strengthen our retirement system, the IRS has made a series of changes to the Required Minimum Distribution (RMD) rules governing almost all retirement accounts. These modifications aim to provide you with more flexibility and growth potential, but they also present new challenges and pitfalls that must be acted on with precision and in a timely manner.

What is RMD?

RMDs are the minimum amounts you must withdraw from IRA, SEP, and other retirement accounts each year once you reach a certain age.

That seems easy enough, right? Well, that’s where the first set of complexities pops up.

In 2019, Congress passed the first Secure Act, raising the RMD age to 72 from 70½, which was a bit tricky. Most of us don’t keep close track of our half-birthdays!

Then, at the end of last year, Secure Act 2.0 was approved. It raised the RMD age by another year, to 73, effective this year. That means if you were born in 1950 or earlier, you must start taking RMDs this year. Anyone born in 1951 or later gets to wait. And for those born in 1960 or later, RMDs won’t kick in until age 75.

Here’s why it matters that you start on time and take out the correct amount each year: the IRS says you may face “stiff penalties” for failing to do so. How stiff? The excise tax penalty for failing to take out enough money is 25 percent (it used to be 50 percent), even though the penalty could be lowered to 10 percent if you correct your mistake within two years.

How Do You Calculate How Much to Withdraw Each Year?

The IRS, many financial service firms, AARP, and others offer online worksheets to help you figure out how much you must withdraw each year, and the amount does vary from year to year.

It’s based on your age and life expectancy, the relative age of your spouse, and the balance of your accounts as of December 31 of the prior year. Many people have more than one IRA or comparable accounts. You must calculate the RMD for each account, but you can aggregate the total and withdraw the required amount from just one of those accounts.

However, the rules differ for 401(k) and 403(b) accounts. You must take withdrawals from each of those plans separately.

Either way, the calculation is based on estimating how many years you will need to take RMDs before you drain your account. If you are 73 this year, the life expectancy table gives you 24.7 years of distributions.

Why Are These Accounts Taxed At All?

IRAs are tax-deferred accounts. You and your employer contributed pre-tax dollars. You postponed the payment of taxes, but you did not eliminate them. Eventually, the tax bill comes due, and the RMD ensures you pay it.

Figuring how much you need to withdraw involves several calculations, and as we said, getting it wrong can be costly. The penalty can be as high as 25 percent!

How much you owe in taxes is based on how much money you withdraw and your income tax bracket. The withdrawal is considered ordinary income. For example, if you withdraw $4,000 this year and are in the 25 percent tax bracket, you would owe $1,000.

Is There a Way to Reduce the Tax Liability?

There are three main ways to reduce your tax liability. One requires action in the years before you begin to take RMDs.

You can move money from a traditional IRA into a Roth account each year, but you will pay tax at the time of conversion. There is a double benefit to a conversion. Not only does it reduce the amount of money that is subject to RMD and taxes, but it also reduces the tax burden on your heirs.

The other legal tax avoidance action is to give away all or part of your RMD withdrawal. The IRS allows a person over age 70.5 to donate up to $100,000 a year directly to a charity through what is known as a Qualified Charitable Distribution (QCD). This amount increases to $105,000 in 2024. Make sure that the money does not touch your hands. It must be made directly to a qualified charity. QCDs may make the most sense if you plan to use the standard deduction instead of itemizing your tax deductions.

A third alternative is a Qualified Longevity Annuity Contract (QLAC), which allows you to convert up to $200,000 from your IRA into an annuity contract. The amount you contribute is not subject to a required minimum distribution. Still, the income you receive from the annuity is subject to taxes at the ordinary income rate and must be withdrawn no later than age 85.

The Rules on Roth IRAs Are Different

Unlike traditional IRAs, there are no RMD mandates for Roth IRAs and Roth 401(k)s during the account owner’s lifetime.

In addition, because Roth accounts were funded with after-tax dollars, you will not have a tax bill if you start withdrawing funds. You already paid tax in the year in which you made the contributions.

Beneficiary IRAs

Beneficiaries of your Roth account (other than your spouse) will be subject to RMDs. They have a 10-year window to empty the account.

If the date of death is in 2019 or prior, the required minimum distribution is based on your age in the year after the year of death.

If the date of death is in 2020 or after, you have ten years to take out the funds, beginning with the year after death. There is some uncertainty concerning whether the beneficiary must also take a minimum distribution each year. Recent IRS Notice 2023-54 delays annual RMDs until no earlier than 2024 from inherited IRAs from a decedent who had been taking RMDs.

Other Notes About RMDs

• Make sure you budget for the taxes owed on these distributions. Not only will you pay at the ordinary income tax rate, but the RMD could throw you into a higher tax bracket.
• You don’t have to take your first withdrawal until April 15 of the year after your magic age, but if you wait, you will have to take two withdrawals that year, which could lead to a much higher tax bill.
• Don’t wait until the end of December to make your withdrawals. Many brokerage firms require a few weeks’ notice because of the holidays and the end-of-year business crush. Failure to receive your distribution on time could result in the penalties previously discussed. Contact us if you’re concerned about the timing.
• You can take your RMD as a lump sum, quarterly or monthly, but the tax bill will be the same no matter what.
• If you are still working, RMDs on 401(k) and 403(b) accounts can generally be deferred.

As we said at the beginning, it’s complicated. Careful planning benefits people at every stage, whether nearing retirement, already retired, and those who will one day inherit retirement accounts. Don’t hesitate to contact us if you have any questions.