Required Minimum Distributions: What You Should Know

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 after a certain age. 

Effective January 1, 2023, SECURE Act 2.0 changed the age at which RMDs kick in from 72 to 73. This means individuals who turned 72 in 2022 are covered by the old rules—they should have already taken RMDs for last year and will also need to take RMDs in 2023 to avoid penalties. Those who turn 73 in 2024 will be able to wait until April 1, 2025, to take their first RMDs.

"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.

In general, once you reach age 73 (or age 72 for tax years before 2023), 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)s in 2023 but not from 2024 onward because of changes in SECURE Act 2.0¹ (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.

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 ÷ 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.

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 73rd birthday (or 72nd birthday for the 2022 tax year). 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 the year rather than wait until April 1."
• You're still working. If you're enrolled in your current employer's qualified retirement plan and you don't own more than 5% of the business, you may be able to delay taking RMDs from that account until April 1 of the year after you retire – check with your plan administrator to confirm. However, you must continue taking RMDs from all other tax-deferred retirement 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: 

• For 2023 onward, the penalty will be 25% of the amount you failed to withdraw.² For example, if your RMD was $100,000 but you withdrew only $50,000, you'd owe a quarter of the shortfall ($12,500) as a penalty.
• For tax years before 2023, the penalty is even higher, at 50% of the amount you failed to withdraw. Using the same example, if you only withdrew $50,000 for 2022, your penalty would be $25,000.

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.

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:

Once you reach age 59½, 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.

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."

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 your RMD age, 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 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. 

"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."

Taking your full RMD and then donating cash could result in a higher tax bill than if you were to give through a QCD.

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.