For many investors entering their 70s, diligently contributing to tax-deferred retirement accounts must soon turn to diligently drawing them down. That's because the government requires retirees to take required minimum distributions (RMDs) from such accounts starting at age 72.
"Many retirees are daunted by RMDs, in part because of the steep penalties for withdrawing too little," says Hayden Adams, CPA, CFP®, director of tax and financial planning at the Schwab Center for Financial Research. "But RMDs really aren't so complicated once you understand a few basics."
With that in mind, let's take a look at how to calculate your RMDs, how to manage the distributions effectively, and how to potentially reduce the associated tax hit.
1. Do the math
In general, once you reach age 72, you must begin taking annual RMDs from all tax-deferred retirement accounts, including:
- 401(k), 403(b), and similar workplace retirement plans—including Roth 401(k)s1 (see "The rules around Roths," below)
- SEP IRAs
- SIMPLE IRAs
- Traditional IRAs
Generally speaking, you can calculate your RMDs for a given year by taking your account balance on December 31 of the prior year and dividing it by your "distribution period"—a number the IRS assigns to each age beginning at 72 (see "Running the numbers," below).
Running the numbers
A simple calculation can help you determine your RMDs for the year.
Source: IRS publication 590-B (2022 draft version).
Table does not include the distribution period for all ages. A separate table is used if the sole beneficiary is the account owner’s spouse who is 10 or more years younger than the owner.
For example, let's say you're 75, single, and ended last year with $2 million in your IRA. According to the table above, your distribution period is 24.6—which means your RMD for the year would be $81,301 ($2,000,000 divided by 24.6). If you have multiple tax-deferred retirement accounts, RMDs must be calculated separately for each one.
Many financial institutions, including Schwab, will calculate your RMDs for you—and may even offer automated withdrawals—but typically only for the accounts held at their firms. "Those looking to streamline their RMDs might consider consolidating their retirement accounts with a single firm to reduce the odds of withdrawing too much or too little," Hayden says.
The rules around Roths
If you'd like to avoid taking RMDs from your Roth 401(k), the easiest solution is to roll the funds into a Roth IRA before you reach age 72. "Doing so allows that money to remain invested for tax-free growth," Hayden says. "Plus, you'll generally have more investment options with an IRA than you would with a 401(k)."" id="body_disclosure--media_disclosure--50211" >
RMDs also are required from Roth 401(k) accounts, despite those accounts being funded with after-tax dollars. "This rule surprises a lot of people because it differs from Roth IRAs, whose funds can stay invested indefinitely during the account owner's lifetime," Hayden says.
If you'd like to avoid taking RMDs from your Roth 401(k), the easiest solution is to roll the funds into a Roth IRA before you reach age 72. "Doing so allows that money to remain invested for tax-free growth," Hayden says. "Plus, you'll generally have more investment options with an IRA than you would with a 401(k)."
2. Take the money—or else
You must withdraw your entire RMD amount by December 31 of each year, with two possible exceptions:
- It's your first RMD. You may choose to delay your first RMD until April 1 of the year following your 72nd birthday. However, delaying your first distribution means taking your first and second RMDs in the same tax year, which could significantly increase your taxable income. "This strategy may make sense if you’re still bringing in steady income," Hayden says. "But for most people, it's usually better to take the distribution by the end of their 72nd year."
- You're still working. If you're an active participant in your current employer's qualified retirement plan and you don't own more than 5% of the business, you can delay taking RMDs from that account until April 1 of the year after you retire—but you must continue taking RMDs from all other accounts.
Those with significant savings should carefully consider whether it makes sense to delay withdrawals. "By postponing those distributions, you're allowing your savings to potentially grow even more in the intervening years," Hayden says. "That's not bad per se, but it does mean you could see a significant bump in the size of your RMDs, and thus your tax bill, once you retire."
If you miss a deadline or don't withdraw your full RMD, the penalty is stiff: 50% of the amount you failed to withdraw. For example, if your RMD was $100,000 but you withdrew only $50,000, you’d owe half the shortfall ($25,000) as a penalty.
As for when in the year to take your RMDs, it will ultimately depend on your income needs and personal preferences. For example, some may choose to take a lump-sum distribution at the beginning of the year so they don’t have to think about it again until the following year, while others might find that taking regular withdrawals is the simplest way to meet their RMD requirements and manage their cash flow. However, Hayden cautions against waiting to take RMDs until the end of the year. "You don't want to accidentally forget about them during the holidays," he says.
Regardless of when and how you take your withdrawals, you should view it as an opportunity to revisit whether your asset allocation is still in line with your risk tolerance and rebalance as needed.
"That way, you're satisfying your RMDs for the year and ensuring your portfolio continues to be aligned with your goals," Hayden says.
3. Be tax smart
Retirees sometimes find that their RMDs provide more income than they need in a given year. "What's more, when combined with other income sources, like dividends and interest payments, RMDs can push you into a higher tax bracket and could affect the taxation of Social Security benefits and the premiums you pay for Medicare," Hayden says.
If you're worried about the effects of RMDs on your tax bill and health care costs, there are several strategies you can employ before and after age 72 to reduce them:
Make withdrawals prior to age 72
Once you reach age 59 1/2, you can make penalty-free withdrawals from tax-deferred accounts. The distributions are still taxed as ordinary income, but over time they will reduce the size of your tax-deferred accounts—and hence your RMDs once you reach age 72 (see "Now vs. later," below).
When employing this strategy, it helps to think of it as tax-bracket optimization. For example, if you're a joint filer in the 24% tax bracket and you have $200,000 in taxable income from a business, you could withdraw another $140,000 from your tax-deferred accounts and stay in your current tax bracket.
"The idea is to select a tax bracket that makes the most sense for your circumstances—and then fill up that bracket with distributions from your tax-deferred retirement accounts each year," Hayden says. "Those funds can then be reinvested in a taxable brokerage account, and if invested tax efficiently, could produce very little additional taxable income each year."
Now vs. later
Drawing down tax-deferred accounts without penalty starting at age 59 1/2 can reduce your RMDs starting at age 72—and help keep taxes in check.
Source: Schwab Center for Financial Research.
Calculations assume a married couple with $200,000 in combined taxable income and $2 million in combined tax-deferred accounts at age 59½. Annual growth of 6% is added to the account balance at the end of each year, and nonportfolio income and tax brackets increase by 2% annually to account for inflation (based on current tax rates). This example is hypothetical and for illustrative purposes only.
A Roth IRA conversion
Another way to optimize your tax bracket and potentially reduce future RMDs is to convert some of your tax-deferred savings to a Roth IRA in the years leading up to age 72, since such accounts aren't subject to RMDs.
You'll have to pay tax on the converted amount at the time of the conversion, so it's generally a good idea only if you think your tax bracket in retirement will be equal to or higher than it is now.
"Taxes are historically low, so it's possible they could go up in the future," Hayden says. "But the decision ultimately comes down to whether you're comfortable locking in today's tax rates on the converted funds."
A qualified charitable distribution
A QCD allows you to donate up to $100,000 per year from an IRA directly to charity—and use some or all of those funds to satisfy your IRA RMDs for the year. For example, if your RMD for the year is $100,000 but you need only $50,000 of that, you could donate the remaining $50,000 via a QCD to satisfy the rest of your RMD (see "Cash vs. QCD," below).
"QCDs can be a great tool for philanthropy as well as managing taxable income in retirement," Hayden says. "Just be aware that QCDs are not permitted from 401(k)s or other qualified plans."
Cash vs. QCD
Taking your full RMD and then donating cash could result in a higher tax bill than if you were to give through a QCD.
Take RMD of $100,000 and donate $50,000 in cash
Nonportfolio income: $50,000
Annual RMD: + $100,000
QCD: + $0
Pretax income: = $150,000
Itemized deduction: – $50,000
Taxable income: = $100,000
Estimated taxes due: $17,836
Take RMD of $50,000 and donate $50,000 using a QCD
Nonportfolio income: $50,000
Annual RMD: + $100,000
QCD: – $50,000
Pretax income: = $100,000
Standard deduction: – $14,700
Taxable income: = $85,300
Estimated taxes due: $14,383
Note: This example is hypothetical, for illustrative purposes only, and should not be considered tax advice. Tax calculations are estimated using 2022 federal tax brackets for a single filer, do not reflect state taxes, and assume that 85% of Social Security benefits are taxable. In 2022, the standard deduction for individuals ages 65 and older is $14,700 ($12,950 standard deduction plus $1,750 of additional deductions based on age).
When implementing an RMD-reduction strategy, there's no substitute for personalized advice from a tax professional who knows the details of your individual situation. "A professional can help you anticipate potential challenges and consider how these strategies fit into your overall financial plan," Hayden says.
1 Certain qualified plans can allow for those who are still working to forgo RMDs until their employment is terminated.