Required Minimum Distributions (RMDs) are an important part of retirement planning that some retirees find challenging. And several major retirement savings plan rule changes due to the SECURE 2.0 Act only add to the confusion.
That’s why understanding and avoiding common RMD mistakes and their implications can help you potentially save money.
So, in no particular order, let's explore seven potential tax implications associated with required minimum distribution errors.
Note: Keep in mind these are some common mistakes (not all the mistakes that can happen with RMDs) and tax implications vary.
1. Miscalculating the RMD Amount
One key mistake is incorrectly calculating the RMD amount.
Many retirees struggle with accurately determining their RMD due to confusion about which IRS life expectancy table to use or how to account for year-end account balances. This can result in insufficient withdrawals and potential penalties.
For instance, if you have multiple retirement accounts, you might need to aggregate their values for RMD calculations.
- Generally, to calculate your RMD, you need to find your account balance as of December 31 of the previous year.
- You look up your life expectancy factor from the IRS table based on your age when you take the RMD.
- Then, use the formula RMD = Account Balance divided by Life Expectancy Factor.
For example, if your account balance is $100,000 and your life expectancy factor is 26.5, the calculation would be RMD = $100,000/26.5. So, the RMD amount = $3,773.58. (The IRS has worksheets that can help.)
Tax Implication: If you withdraw less than the required amount, you could face a 25% penalty of the undistributed amount. This penalty would be in addition to the regular income tax owed on the distribution.
2. Missing an RMD Deadline
Another RMD error is forgetting to take your RMD by the annual December 31 deadline (or April 1 for your first RMD).
Tax Implication: The IRS imposes a 25% penalty on the amount not withdrawn by the deadline. (This penalty percentage has decreased significantly due to SECURE 2.0 legislation.)
However, if you correct the mistake within two years, you may be eligible for a reduced penalty of 10%.
3. Inherited IRA RMDs
Many beneficiaries might need to take RMDs from inherited retirement savings accounts even if they haven’t reached the typical RMD age (73).
Most beneficiaries must withdraw these amounts within 10 years following the account holder's death (the "10-year rule"), with specific rules depending on the beneficiary's relationship to the deceased.
Tax Implication: Failing to take RMDs from inherited IRAs can result in the same 25% penalty as missing RMDs from your accounts. That’s why beneficiaries need to know their responsibilities with inherited accounts.
4. The "still working" exception
Some believe they can delay RMDs from all their retirement accounts if they're still working past age 73. However, this exception only applies to your current employer's sponsored plan, like a 401(k), not to IRAs or previous employers' plans.
Tax Implication: Incorrectly applying this exception can lead to missed RMDs and associated penalties for accounts not covered by the still-working exception.
5. RMD aggregation rules
While you can aggregate required minimum distributions from multiple IRAs and take the total from one account, this rule does not apply to all retirement accounts.
Specifically, RMDs from 401(k) plans must be calculated and withdrawn separately for each account, meaning they cannot be combined with RMDs from IRAs.
Tax Implication: Misapplying aggregation rules can result in insufficient withdrawals from certain accounts, leading to penalties on the undistributed amounts.
6. Market fluctuation adjustments
Your RMD is based on your retirement account balance at the end of the previous year. So, not accounting for significant changes in your portfolio's value in volatile markets could lead to miscalculations.
Tax Implication: Market downturns might impact your RMD. And not adjusting for upswings could lead to insufficient withdrawals and associated penalties. Consult a qualified tax or financial planner to help determine the best strategy for your situation.
7. QCD limits
Some retirees don’t know they can fulfill their RMD by making a Qualified Charitable Distribution (QCD) directly from their IRA to a qualified charity.
- This option allows individuals aged 70½ and older to donate up to $105,000 annually without being counted as taxable income.
- By using QCDs to satisfy RMD requirements, retirees can support charitable causes while minimizing the impact on their taxable income.
Tax Implication: While not a penalty, missing opportunities like QCDS, if eligible, could result in higher taxable income than necessary.
High taxable income in retirement can impact taxes on Social Security benefits and push retirees into higher tax brackets.
As Kiplinger has reported, your modified adjusted gross income (MAGI) in retirement can also increase Medicare premiums and limit eligibility for certain deductions and credits.
RMDs: Bottom Line
RMDs often impact your tax situation and overall finances in retirement. As a result, understanding these and other common RMD mistakes and their tax implications is important for effective planning.
Remember, however, that these are merely some common mistakes (not all mistakes that can happen with RMDs) and tax implications vary.
So, stay informed and plan; consult a financial advisor or tax professional if you’re uncertain about how RMD rules impact you.
