Why RMDs are a Ticking Time Bomb

Meet Suzan, a 72-year-old who recently retired as a high school teacher. She consistently saved for retirement in a tax-deferred account.

Suzan enjoys a comfortable retirement lifestyle with income from her social security benefits, pension, and rental income from a few properties she owns.

What happens when Suzan turns 73 and must start taking the required minimum distributions?

Understanding a Required Minimum Distribution?

A requirement minimum distribution (RMD) is the minimum annual total amount a retiree must withdraw from their tax-deferred retirement account, such as a 401(k) or traditional individual retirement account (IRA).

A retiree must take their RMD by April 1, following the year they turned 73. If you turn 73 in 2024, you must withdraw your first RMD by April 1, 2025. Subsequent withdrawals must be made annually.

The Internal Revenue Service (IRS) may charge a penalty for failing to take your RMD or the correct amount. This penalty could be 10%, 25%, or 50% of the amount not taken.

For retirees like Suzan, taking RMDs can significantly increase their total taxable annual income. This will likely bump them into a higher tax bracket and cause them to owe more income taxes than they previously did.

How to Calculate Your RMDs

The formula the IRS uses to calculate a retiree’s RMD divides their account balance by the life expectancy factor. In short, RMD = total account balance/life expectancy factor.

The total retirement account balance is the value of your account by the end of business on December 31 of the year before you take your RMD.

The life expectancy factor comes from the appropriate IRS table, such as Table I (Single Life Expectancy), Table II (Joint Life and Last Survivor Expectancy), or Table III (Uniform Lifetime).

Let us illustrate with an example: Suppose the balance on Suzan’s traditional IRA on December 31, 2024, is $200,000. Her spouse is 62 years old, meaning they’re more than 10 years younger, and they’re the account’s sole beneficiary.

Using Table II, the life expectancy to use is 27.2. Suzan’s current RMD will be $7,352.94 ($200,000/27.2 = $7,352.94).

Because Suzan’s retirement account balance, her age, and her spouse’s age change, her RMD will also change.

It’s important to eliminate or reduce the impact of RMDs on your retirement finances to minimize taxes. One efficient way is to open a retirement account you contribute to with after-tax income, such as a Roth IRA.

The Impact of RMDs on Your Beneficiaries

The RMD rules vary based on who inherits your retirement account: a spouse or a non-spousal beneficiary. Also, consideration is given to whether the retirement account holder died before or after they started taking RMDs.

If the owner dies after starting to take RMDs, their spouse can open an Inherited IRA in their own name using the 10-year method.

The spouse will have to take RMDs up to December 31 for 10 years following the original account owner’s death. By then, the account will need to have been depleted.

If these withdrawals occur during the beneficiary’s highest income years, their inheritance will diminish significantly.

Conclusion

If you would like to avoid the RMD time bomb, review your retirement accounts for tax impacts. JDH Wealth is available to help if you are interested in financial planning for yourself or your beneficiaries.