As I discuss with clients the things that will differ in retirement relative to their working years, I often need to explain a new and strange concept called a Required Minimum Distribution or RMD. Since it can be such a foreign concept to most people, and it’s one of the most frequently asked questions, it’s worth reviewing some basics. 

The word that sometimes catches people off guard in this discussion is “defer.” By saving in a Traditional 401(k), Traditional IRA, or similar pre-tax retirement vehicle, you are electing to defer income taxes into the future.  (See footnote 1.)

The simplest way I can describe an RMD is by personifying the IRS and imagining them saying: 

"We at the IRS are glad you saved for retirement by putting money into your tax-deferred retirement accounts. The IRS has not seen you pay any taxes on these accounts for a long time. Now that you are 72 or older, the IRS requires you to take out a little bit each year and pay some taxes in the process."

Another way of saying this is that you defer the taxes into the future by using a pre-tax retirement account during your working years. The RMD is, in effect, turning the future into the now. 

Here are the things you need to know but were afraid to ask: 

The RMD is a required annual ritual. If you miss this yearly ritual, the IRS imposes a penalty of 50% of the RMD amount. The 50% penalty is on top of the tax liability owed. By way of example, if you are required to take out $10,000, and your effective tax rate is 15%, then you will effectively only take home $3,500 after paying the taxes and penalties. The good news is that your financial professional will know about this penalty and move mountains to help you avoid it. 

The RMD starts in the year that you turn 72 with a distribution percentage of about 4%, and the percentage goes up each year after that. The percentage to be distributed is a factor of your age; at age 72, it is approximately 4%, about 5% at age 80, and about 9% at age 90. The distribution percentage is based on an IRS calculation; the distribution percentage is multiplied by the closing account balance of the previous year, resulting in the RMD dollar amount. (See footnote 2.)  

The RMD amount is the minimum amount. If you are taking more, you have satisfied your RMD for the year. If your distributions for living expenses exceed your RMD amount, you have effectively satisfied your RMD for the year. By way of example, if you are taking a $1,000 monthly distribution from your IRA and your RMD is $10,000, you have more satisfaction than satisfied the RMD. 

The IRS doesn’t care what you do with the money. They only care that you pay the taxes. I’m often asked by clients what they should do with the money they are taking out for the RMD. The answer will be different for different people but should fit into the context of your unique financial plan. In some cases, it might make sense for the withdrawal to be treated as a part of the cash flow to fund your living expenses. In other cases, when you don’t need the money to live on and would prefer it to stay invested, you can transfer it out of the retirement account and into a taxable vehicle such as a Trust. 

Distributions from a tax-deferred account are treated as “ordinary income.” The simplest way to describe this is that it will appear at the top of page one of your tax return. The word “ordinary” means it will be taxed at your ordinary-income tax rate. One thing that makes distributions from a retirement account different from earning income: The “social taxes” (i.e., Medicare and Social Security) are paid at the time of deferral to the retirement account and are not applicable at the time of distribution from the retirement account. 

Retirement account distributions generate a 1099R tax form. When you take a distribution from a retirement account, you will receive a 1099R tax form from the company that maintains the account. The 1099R is a relatively simple form to prepare and is usually available in mid-January every year. 

You can take your RMD anytime during the calendar year, and you should decide when to take it based on your needs. Because the penalty is very stiff for missing an RMD, some institutions and financial advisors will simply process the RMD on your behalf towards the end of the year, with November being a very popular month for this to happen. 

The conventional wisdom behind waiting until late in the year is that the assets have the most time to grow before they are distributed. However, that might not meet the needs of every client, and you should decide when to take your RMD based on your unique situation. For example, I have a client who takes his RMD on the first possible day we can process it. He wants the cash on hand so that he can then budget his travel for the year. Another client takes their RMD every month to help with daily living expenses. They like knowing the check will show up each month, just like a paycheck. A third client has decided to make quarterly payments to the IRS and takes a quarterly distribution to help make that quarterly payment. And a fourth client, a couple, takes the distribution for one spouse in January and the second spouse in November. In so doing, they feel they are mitigation risks of market movements.

Your RMD might be larger than you expect. There are potential scenarios where your RMD is quite a bit larger than you would expect and may significantly impact your tax return and marginal tax bracket. If a 90-year-old client has an IRA with a balance of $1 million, the RMD will be just over $100,000. I have worked with clients where the RMD alone pushed them into the highest tax bracket. It may make sense to do some tax planning to manage your RMD better.

There is no way to avoid income taxes…sort of. One general rule that applies to the pre-tax retirement account is that someone, someday, must pay the deferred income taxes. That means that if you die and pass on your retirement account to a loved one, that person will be responsible for paying the taxes on distributions. There are two exceptions to this rule. 

Exception 1 is called a Qualified Charitable Distribution, or QCD. The QCD allows someone, in place of an RMD, to distribute funds directly to a qualified charity. Since charities don’t pay income taxes, this distribution is effectively tax-free. The maximum amount for this is $100,000 (as of 2022), is not currently indexed for inflation, and is only available to those taking an RMD. 

Exception 2 is if you make a qualified charity your designated beneficiary. At your death, the pre-tax retirement account would transfer to the charity. Since the charity does not pay income taxes, the entire amount would be distributed tax-free. 

Roth conversions will help reduce your RMD, but only in future years. A Roth conversion is a taxable transfer from a pre-tax retirement account to Roth IRA account. It is a choice to pay the taxes today and avoid any future taxation. You can convert as little as $1 or as much as 100%.  

One gotcha is that you can not do the Roth Conversion in place of the RMD. A Roth conversion is always in addition to the RMD. If your RMD is $10,000 and you’d like to do a Roth conversion on $10,000, you will receive a 1099R showing a total taxable distribution of $20,000. Your RMD will be smaller in future years relative to not having done a Roth Conversion, but your current year's tax bill will be larger. 

The Roth Conversion can be a smart strategy but is dependent on your situation and plan. I have had clients do Roth conversions, have seen their current year tax bill bump up, and swear “never again!” Alternatively, I have had clients aggressively implement the Roth conversion strategy to get the pre-tax retirement account balance to zero. 

There are a few well-documented cases where people have strategically decided to pay a LOT in taxes to do a Roth conversion. In one well-documented case, an investor had a huge pre-tax IRA and chose to pay $29.2 million to convert the entirety of his IRA into a Roth IRA. The savvy investor reasoned that despite having a huge tax bill in one year, he would pay less in taxes over his lifetime (and the lifetimes of his heirs) by taking this bold move. 

Keep it simple and pay your taxes. You can withhold taxes when you take money out of a pre-tax retirement plan. Unless you have worked explicitly with your tax professional to be on a quarterly payment plan with the IRS, the easiest, safest, and most straightforward thing to do is withhold taxes at the time of the distribution. I have seen people choose not to withhold taxes, assuming they will true up in April the following year, only to find themselves in a non-virtuous cycle. If you find yourself owing taxes in April when you file your tax return and take a distribution in which you don’t withhold taxes to pay the tax bill, you will end up in the same spot 12 months later. 

Inherited IRAs have a different set of rules. The rules for Inherited IRA’s are complicated and warrant a separate post. 

That’s it! It’s easy, right? Don’t worry; it will become an annual routine and become easier every year. And you can always reach out to your financial advisor or institution for help.

Footnotes:

1. Other types of tax-deferred accounts include Traditional IRAs, Rollover IRAs, SEP IRAs, SIMPLE IRAs, 401(k) plans, 403(b) plans, 401(a) plans, 457(b) plans, Profit Sharing (PS) plans, as well as other types of Defined Contribution (DC) plans

2. The IRS table has a “distribution factor,” and the distribution percentage is simply one divided by the distribution factor. If your distribution factor is 25.6, the distribution percentage is 3.9% or 1/25.6. The distribution factor is an actuarial calculation representing an estimate of the amount required each year to draw the account down based on life expectancy. 

Other useful links: 

IRS website on RMD: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds 

Downloadable IRS RMD Worksheet (in PDF Format): https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf 

RMD Calculator: https://www.schwab.com/ira/understand-iras/ira-calculators/rmd

Original ProPublica article that discussed massive Roth conversions: https://www.propublica.org/article/lord-of-the-roths-how-tech-mogul-peter-thiel-turned-a-retirement-account-for-the-middle-class-into-a-5-billion-dollar-tax-free-piggy-bank 

Response to ProPublica inquiry that provides more details behind a massive Roth conversion: https://www.documentcloud.org/documents/20971124-ted-weschler-statement

Disclosures: Context Wealth, nor any of its members, are tax accountants and do not provide tax advice. For tax advice, you should consult your tax professional. Investment advisory services are offered through Mutual Advisors LLC DBA Context Wealth, an SEC registered investment adviser.