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ABCs of RMDs

When to take required minimum distributions, how to calculate them, and strategies for lowering RMD-related taxes.

Required minimum distributions, or RMDs, are exactly as they sound—they’re mandatory distributions, or withdrawals, of funds from retirement accounts. Your RMD is the minimum amount you have to take out of your tax-deferred retirement accounts once you pass age 72. RMDs apply to traditional IRAs, 401(k)s, 403(b)s, and SEP IRAs. One notable retirement account type that isn’t subject to RMDs during your lifetime is the Roth IRA. RMDs also apply to some inherited retirement accounts, but today I’m going to be talking about retirement accounts that you own during your own lifetime.

One question that often comes up in relation to RMDs is why we have to take them. The main idea is that tax-deferred retirement accounts aren’t taxable while you’re saving and accumulating assets for retirement. But once you hit age 72, RMDs are the government’s way of saying that the party is over: It’s time to start pulling the money out and paying taxes on those withdrawals. You’ll typically owe ordinary income tax on your RMDs, unless you’ve contributed aftertax dollars to your account. If that’s the case, those contributions won’t be taxed again, though any investment earnings on those amounts will be. 

You have to take RMDs annually, by Dec. 31 of each year. If you miss your RMD, you’ll owe any taxes that would have been due on your RMD amount, and you’ll also owe a 50% penalty on any amount that you should have taken but didn’t. In other words, you don’t want to miss your RMD. 

To calculate your RMDs, you look back to your account balance at the end of the previous year. You then divide that amount by what’s called a life expectancy factor, which you can find on the Internal Revenue Service’s website. There are different tables for RMDs, but most people will use what’s called the Uniform Lifetime Table. You’ll use a separate table if your spouse is more than 10 years younger than you and is the sole beneficiary of your retirement account. 

You’ll see that the RMD percentages increase as you age. They start at less than 4% of your portfolio at age 72, but by age 80, they’re over 5%. That might make you feel uncomfortable if you’re trying to stick to a specific withdrawal percentage on your retirement portfolio. But remember—you can always reinvest the money; you don’t have to spend it. If you have earned income equal to or greater than your contribution amount, you can even reinvest your RMD proceeds back into an IRA.

More-affluent investors also wonder if there’s anything they can do to lower their RMDs and, in turn, their tax bills. One idea for lowering RMD-related taxes is what’s called a qualified charitable distribution, which you’re eligible to make once you turn age 70 and a half. That means that you can take a portion of your IRA, up to $100,000 per year, and donate it to charity. Any amounts that you donate to charity in this way aren’t taxable, and they also satisfy your RMD obligations. Another idea is a type of deferred annuity called a qualified longevity annuity contract, or QLAC. The amount you put into the QLAC isn’t subject to RMDs, but you’ll owe taxes when you begin taking income from the annuity. 

Thanks for watching. I’m Christine Benz for Morningstar.

Read more: When's the Right Time to Take RMDs?