Understanding Required Minimum Distributions (RMDs)

Published On: February 4, 2021

Written by: Ben Atwater and Matt Malick

For clients who must take required minimum distributions (RMDs) from retirement accounts in 2021, Fidelity is currently mailing you notices.  Unless you would like to take your RMD now, please do not worry about these notices as we will be in touch.  It is our practice to reach out toward the end of the year to assure all clients have taken their RMDs. 

Now is a good time to review the ins and outs of RMDs.  RMDs play a key role in retirement income planning, tax management and estate planning.  Throughout the year, we get lots of questions about RMDs, particularly among those who have not yet started taking RMDs.  So, here we go . . .

Retirement accounts allow individuals to save in a tax-advantaged manner. The contributions are often tax- deductible, and the account’s growth is tax-deferred. In these cases, however, investors do not get off tax-free forever.

Rather, you need to pay taxes when you withdraw from IRAs, 401(k)s and the like. Because these accounts are intended to help you fund your retirement, Congress designed the plans to require that you withdraw funds upon reaching age 72 (pre-2020, the age was 70 ½). 

Like most things Congress does, RMD rules are unreasonably complex. So, let us take a few minutes to look at the basics.

RMDs generally must begin after age 72. However, if you continue working after age 72 and are not a 5%+ owner of the company, you can delay your beginning date for RMDs associated with certain employer plans while you are still an active plan participant. 

If you are in this situation (72 or older, still working, participating in certain employer plans and less than 5% owner of the company), you can also roll IRAs and inactive 401(k)s into your current employer plan to avoid RMDs. Any outside account that you do not combine with certain employer plans, however, will continue to require RMDs.

If you do not need your RMD for income purposes, another tax avoidance strategy is to donate your RMD to charity and not have it count toward your taxable income. The IRS calls these qualified charitable distributions (QCDs), which allow individuals age 70½ years or older to donate up to $100,000 per year to one or more charities directly from their IRAs.   

Such a strategy may keep donors in a lower income tax bracket, keep Medicare premiums down and take tax advantage of a charitable contribution even if you no longer itemize your deductions given the $26,450 2021 standard deduction for seniors.  Please note, the age for QCDs remains 70 ½ even as Congress raised the initial age for RMDs to 72 for 2020 and beyond.

When an individual reaches age 72, he must take his first RMD by April 1 of the following year. This is a bit confusing because subsequent RMDs are due by December 31st of each year. For example, if you turned 72 on June 20, 2020, your first RMD would be due by April 1, 2021. However, your 2021 RMD would be due as well before December 31, 2021.  As such, if you deferred your first RMD to 2021 because, for example, you still had earned income in 2020, then you would need to effectively take two RMDs in 2021. 

RMD distributions are federally taxable at your marginal tax rate. For this reason, most people turning 72 take the first distribution in the year they turn 72 to spread out the tax liability, unless there is a specific tax reason not to do so.

We calculate RMDs by dividing the account balance from the end of the previous calendar year by a life expectancy factor the IRS provides.

For example, assume your IRA had a balance of $1,000,000 on December 31, 2020. We use this prior year-end IRA value for the calculation. If you turned 75 in 2020, we find age 75 on the table and the corresponding applicable distribution period denominator of 22. By dividing $1,000,000 by 22, we come to $45,454.55, which is the RMD amount you must take from your IRA by December 31, 2021.

If you have multiple IRAs, you can aggregate the account balances and take one distribution to meet the RMDs from multiple accounts. You cannot do this with 401(k)s. If you have inherited IRA accounts, which also typically have RMDs, you generally cannot aggregate them together unless they are IRAs from the same deceased owner or inherited from a spouse and designated as your own IRA.

If you do not take the RMD by the due date, you could owe a 50% tax penalty plus the ordinary income taxes you would owe on the distribution.

For the most part, all retirement accounts (ERISA covered qualified retirement plans and IRAs) are subject to the RMD rules. However, Roth IRAs are different. When an individual is alive, she is not required to take an RMD from Roth IRAs. However, Roth balances in 401(k)s, 403(b)s and the federal Thrift Savings Plan are subject to RMDs after age 72, so it is optimal to roll these plans to Roth IRAs at retirement.

The rules for inherited RMDs are also complex.  For decedents post 2020, the IRS does not require beneficiaries to take RMDs, however, the beneficiary must withdraw the full inherited IRA balance within ten years after the date of the decedent’s death (for non-spousal IRAs).  If the prior owner died before 2020, then the IRS requires RMDs based on the beneficiary’s life expectancy, beginning at the age the beneficiary inherited the IRA.  In these cases, the inherited IRA has the potential to last the beneficiary a lifetime. 

As you can see, something as seemingly simple as an RMD can get quite complex. If you have any specific questions in this area, please feel free to email or call us.  Obviously, this is an important planning area around retirement income, tax management and estate planning.