Required Minimum Distributions and Your 401(k)

Daniel Penzing
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How Big Is Your RMD?

A Required Minimum Distribution (RMD) or Minimum Required Distribution (MRD) is the minimum amount that you have to withdraw from your retirement account each year by the time you reach your required beginning age. This rule applies to IRAs, 401(k)s, 403(b)s, 457(b)s, SAR-SEPs, SIMPLEs, and other retirement accounts that make up the world of Traditional and Roth IRAs. To learn more about RMDs, check out our IRA RMD calculator.

Who was it that said that our dreams determine our future? Apparently, some people have many dreams, or at least one dream is very important to them. But, retirement needs to come right after that dream. And it is essentially the first dream for most people. And even though for some of us it is not a dream but an actuality, it is still a very important step.

This is when those retirement plans need to be fulfilled and your RMD is a crucial part of every retirement plan. In fact, the amount of the RMD is the first thing that you need to know when planning your withdrawals from your retirement accounts such as IRAs or other retirement accounts.

Is Your RMD Taxable?

A required minimum distribution is a minimum amount your 401(k) account owner is mandated to withdraw from his or her account each year. This withdrawal is counted as taxable income and must be reported on your tax return. If you fail to take a RMD, you are subject to substantial penalties.

Is your RMD taxable? This question probably has more than one answer. In fact starting in 2010, there was a second RMD type and we will explain this in a bit.

Why Was There a Need for RMD's?

The IRA (individual retirement account) law was amended in 2006 to require a minimum distribution provision for IRA accounts. The impetus for this provision was the enormous amount of IRA owners who neglected to take an RMD as they approached their required lifetime death age. Some simply forgot, while others were indifferent.

In both cases, we can see that there was a need to have a "nudge" to goad the owner into taking the withdrawal. The minimum distribution requirements for IRA accounts which began in 2008 are similar to those for 401(k) accounts, but the reasons are different.

The IRA minimum distribution requirements are aimed primarily at ensuring that IRA account owners eventually will take the distributions they are legally required to take. The 401(k) minimum distribution rules, on the other hand, are meant as a safety net to protect company plans against funding of accounts that are lost to neglect or mismanagement.

What Are the Rules for Traditional 401(ks)?

If you are the trustee or beneficiary of a traditional 401(k) plan, the Internal Revenue Service (IRS) requires that you begin receiving payments from the plan when you reach age 70.5. These payments are commonly known as required minimum distributions (RMDs), according to the IRS.

As a trustee or beneficiary, you cannot simply take what the business has generated with the 401(k) account. RMDs must be taken from the plan’s balance during the calendar year. The RMD amount is calculated based on the account balance at the end of the prior year, the IRS states.

If you are the trustee or beneficiary of a business’s traditional 401(k) plan, you cannot simply leave the money in the plan and invest it further. Instead, you are required to meet the RMD for the account at the end of each year. Failure to do so will trigger a 50 percent excise tax, the IRS warns.

Even if you have another retirement plan through your business or as an individual, RMDs still apply, the IRS points out. Furthermore, the employer contribution to the 401(k) plans does not count towards meeting the RMD requirement.

Could You Be Exempt From RMDs?

The topic of RMDs or Required Minimum Distributions can be confusing, even for financial professionals. Tapping into a retirement plan is easy, but dealing with an RMD can be a bit challenging. A lot of financial professionals are learning on the go about how to help clients deal with this retirement challenge.

It is important to remember that the IRS handles these distribution requirements. Every year, investors age 70 and older will be subject to an RMD.

To understand RMDs, it is important to understand the difference between a Traditional IRA and a 401K. One of the main differences is the tax status.

When you turn 70 1/2(a year after the standard retirement age of 65), you will be subject to an RMD. In a Traditional IRA, you get to decide when to take the money out, in buckets. The buckets are the RMD.

The standard bucket is based on life expectancy. The percentage that is put in each bucket is based on your life expectancy. The more years of life expectancy, the less the percentage of the distribution is in each bucket. The less years of life expectancy, the larger the percentage of the distribution is in each bucket.

This differs from a 401K. A 401K is an employer sponsored plan and is based on the life of the employee. This is a significant difference between a 401K and a Traditional IRA.

Can You Donate Your RMD?

No, you are not able to donate your RMD. Your RMD must be distributed to yourself or to your spouse in a qualified distribution. If your spouse is younger than you, you may need to draw down your 401(k) account balances. You can use those funds to make gifts to your younger spouse.

This prevents them from receiving a hugh tax bill upon your death and you can pass on your wishes to your beneficiary. This is a great way to avoid estate taxes and ensure that your final wishes are carried out accurately.

The IRS has your back here and allows you and your spouse to control the use of these funds. It is important to consider estate planning so that you will not be overly taxed at death. The government has joint income tax brackets for a reason.

Your last chance to benefit from a 401(k) is to maximize your contributions. You should also leave your beneficiaries the maximum amount in your plan, without erasing them. It is time to plan for your RMD.

In your retirement years, there are estimated required minimum distributions (RMD) that are required by the retiree. The RMD is calculated based on your account balance. Once the RMD is calculated, it will be distributed to either you or your spouse.

What About Roth 401(k) RMDs?

The 2010 Tax Relief Act included provisions to allow some individuals age 70 1/2 and older to make Roth IRA withdrawals. The same was done for those with Roth 401(k)s. The IRS allows withdrawals from both plans, but they are different and not to be confused with each other.

Roth IRA: Individuals can make traditional IRA withdrawals or Roth IRA withdrawals, but not both. All new Roth IRA contributions after this age are already taxed, so the only depleting of funds occurs from traditional IRA returns/withdrawals and ordinary Roth IRA returns/withdrawals.

Roth 401(k): Can only perform taxable distributions. Roth 401(k) is a lot different than a traditional 401(k) account. Since Roth 401(k)s are already taxed at an income level, no withdrawal is taxed again. The only withdrawals that are taxable are those of earnings of previously untaxed dollars.

What About Other Workplace Retirement Accounts?

Let’s look at the other workplace retirement programs …– the defined-contribution plans. These are plans in which the employer sets up an investment account for each employee, and you have the option of contributing to the account.

The most common of these is the 401(k), in which your contributions become tax deductible (assuming the plan follows IRS guidelines; each plan sends you a letter explaining the plan rules). The accounts are nontaxable until a set time in the future, usually when you retire. At that time, you must start taking distributions.

There’s one big drawback to 401(k) plans – most require you to start taking distributions (aka Required Minimum Distributions or RMDs) by the age of 70 and 1/2.

What About My IRA?

There are a number of different retirement accounts that allow you to contribute money after tax, and all of them have different rules regarding distributions. Some of these accounts allow you start taking withdrawals after the age of 59 and 1/2, while some don’t. IRA accounts are probably the best known, but there are other accounts as well, such as the Roth IRA and SEP IRA.

Here’s a brief rundown of the different types of IRAs:

What If You Don’t Take Your RMD?

I’m not going to lie to you. Taking your Required Minimum Distribution (RMD), or the amount your retirement plan must send you each year, can be a bit of a pain.

You can’t roll it over to another account.

You’re required to take it as a cash withdrawal.

You have to decide whether you want the distribution to be paid out in your traditional account, to your beneficiaries upon your death or in annual installments over your lifetime.

And, of course, if you miss the distribution deadline, you’ll be slapped with a penalty.

Summary

Many 401(k) plans at large companies will allow you to defer taxes on your salary and your employer will also contribute to your 401(k) if you set up an automatic contribution each pay period. Also, you will eventually be able to convert your accumulated principal to a lump sum at retirement. However, you should be aware of required minimum distributions or RMDs. These are the minimum amount of 401(k) assets you must withdraw each year after reaching 70 1/2 years of age. After 70 1/2 years of age, you must begin withdrawing your allowed RMD from your 401(k). It is a good idea to have some of your 401(k) in a ROTH with zero RMDs. You can learn more about the ROTH and RMD at this link.

By age 70 1/2, most people realize that their 401(k) is one of the most important assets and should make a concerted effort to withdraw the minimum amount as slowly as possible. If you take out too much too quickly, you could jeopardize the remainder of the retirement fund.