The world of finance and investments is notorious for its extensive use of jargon. With a goal of enhancing financial literacy and making the world of money more transparent, we are committing to a “monthly jargon” post that focuses on debunking various financial terms that are continuously used sans explanation. This month, we are addressing a term often hidden within its more widely-used acronymic form: RMDs aka required minimum distributions. Now, what exactly is an RMD aside from a required minimum that must be distributed? An RMD is a small amount of money that must be taken (or distributed) from an account by the account owner once he or she reaches the age of 70 ½. RMDs only apply to retirement accounts: traditional, SEP (simplified employee pension), and simple individual retirement accounts (IRAs). The RMD must be taken by April 1 following the year the account holder turns 70 ½, and then by December 31 every year thereafter. It’s important to note that an individual is required to start taking RMDs on all applicable accounts starting in the calendar year he or she turns 70 ½. The RMD amount differs for everyone because it is determined by the value of the account and the expected distribution period for the account owner, meaning the years left in one’s life expectancy.
For example, let’s say Sally is 77, and she has an IRA currently worth $250,000. Her RMD is calculated by dividing her account balance as of December 31 of the previous year by her distribution period, which is based on her age on her birthday of the current year. Here is an RMD worksheet from the IRS to help with RMD calculations: IRA RMD Worksheet. In our example, Sally is turning 78 this year, so her distribution period is 20.3. The value of her account as of December 31 last year was $230,000; therefore, the RMD she was required to take by April 1 of this year was $230,000/20.3 = $11,330. Hopefully, she’s taken that by now because there are penalties associated with missing an RMD, one of which involves paying an excise tax of 50% on the amount not withdrawn. Additionally, remember that all applicable retirement accounts have RMDs – if you have multiple IRAs, you must take the RMD for each account separately!
It’s important to note that an RMD is exactly what it says it is – a required minimum – and you may take out more than that if you want or need to. So, why do RMDs exist? The purpose of an RMD is to safeguard against people deferring taxation and accumulating wealth in these accounts to leave for children or other family members, as doing so would allow the inheritors to avoid paying an inheritance tax. With RMDs in place, account owners are forced to withdraw at least a certain amount of the account as taxable distributions on an annual basis. Essentially, the government is making sure it gets its share. Another important note is that once you take your RMD, it is taxed just like normal income, based on your tax bracket at the time and what state you live in.
All in all, RMDs are an important aspect of retirement planning that impacts everyone with some form of an individual retirement account (IRA). When you enter retirement, it’s important to stay on top of the withdrawals in your account to ensure you don’t overlook your RMD and find yourself handing more of your hard-earned money to the IRS than you should be!