Understanding Required Minimum Distributions (RMDs)

by: Joshua P. Itzoe, CFP©, AIF®

Required Minimum Distributions (RMDs) can be a source of considerable confusion for many retirement plan owners.  When must they begin?  How much to withdraw?  When to take them each year?  And where did all these acronyms come from?

Contributions to a retirement plan (whether a 401k, 403b, IRA, etc.) are typically made with pre-tax dollars.  Long term tax-deferred growth is one of the primary benefits of these types of accounts.  However, the IRS does not allow perpetual tax-deferral- at some point they want their money.  Thus, the basic purpose of a RMD is to enable the IRS to collect taxes on previously untaxed money, generally once an individual reaches the age of 70 ½.

Normally, a RMD for any year must be taken by December 31 of that year.  However, the IRS allows a one-time deferral of the first RMD if necessary.  An account owner may wait until April 1 of the year following the year they turn 70 ½.  This is referred to as the required beginning date (RBD).   For simplicity sake, just remember the RBD is a one-time event and marks the time when yearly RMDs must begin.  If you miss a required distribution, the IRS assesses a penalty of 50% of the amount you should have withdrawn.

To illustrate, assume a person turns 70 in January of 2006 and would therefore turn 70 ½ in July of 2006.  Their first RMD is for the taxable year 2006 and must be withdrawn by April 1, 2007 at the latest (this is the RBD).   The account owner could choose to take their first RMD by December 31, 2006 or they could wait to take it by April 1, 2007.  Generally, it is best to take your first distribution in the year that it is due rather than waiting until the RBD.  Waiting would require the owner to take two RMDs in one year and potentially cause adverse tax consequences.  All subsequent RMDs must always be taken by December 31 of the year in question.

In order to calculate an RMD you need two pieces of information.  First, you need to determine your life expectancy (or applicable divisor) by using the tables published by IRS in Publication 590.  Second, you need to know the account balance from December 31 of the year prior to distribution.  For instance, if your RMD is for the year 2006, you need to know the account balance on December 31, 2005.  When you have this information, simply divide the account balance by your applicable divisor to determine the amount of the RMD. 

There are two exceptions to the normal RBD.  The first is if you are still working after age 70 ½ and the second is if you are a teacher and have contributions within your 403b that were made prior to 1987. 

In the first situation, if you don’t own more than 5% of the company, you can delay your RMD to April 1of the year following the year you retire. This is sometimes called the "still working" exception to your RBD, but it only applies to required distributions from employer plans. It does NOT apply to IRAs or any other employer plans if you are not currently working for that company.  In the second, situation, distributions from the pre-1987 money (aka “Old Money”) can be delayed until age 75.  However, distributions must be taken on any money contributed after 1986 (aka “New Money”) once you reach age 70 ½.

Knowing how to effectively take money out of retirement plans is just as important as accumulating it.  While a starting point, it is important to note that this article is not meant to provide all the information necessary to calculate RMDs.  Always consult you financial or tax professional to determine the most appropriate course of action for your individual situation.

The information in this article is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for financial planning or investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.