Understanding the Required Minimum Distribution on Retirement Accounts

The Required Minimum Distribution is the amount that the Internal Revenue Service requires you to draw from your retirement accounts each year once you reach age seventy and a half. Here’s what you must do.

Tax Advantages of Retirement Accounts

Saving for retirement during your career provides you with a double tax benefit. First, income that you put into your 401K or 403B reduces your taxable income. If your gross pay is $109,000 for the year and you put $10,000 into your 401K, your income reported for taxes is $99,000. Second, your savings in that 401K can grow through interest, capital appreciation and dividends tax free until you begin to draw on it in retirement. IRA’s can also grow without being taxed until drawn on in retirement, but if you are involved in a plan through work also, there are income cap restrictions on the current tax benefits.

ROTH Individual Retirement Accounts are funded with after tax income and grow tax free. The contributions are available at any time tax and penalty free. The earnings are available tax free after five years and having reached age fifty-nine and a half.

There are other tax advantaged retirement accounts such as SEP, 457 plans and SIMPLE plans with their own characteristics

For all retirement accounts, money drawn out after age 59 and a half does not incur Social Security and Medicare taxes. States with a state income tax vary in how they treat retirement income, so consult your tax advisor.

When the Taxes Come Due

Anytime that you draw funds from tax deferred retirement accounts you will pay income taxes on the amount taken. If you do so before age fifty-nine and a half, you will also pay a 10 percent penalty. You are not required to draw on retirement accounts until you reach age seventy and a half, when the IRS forces you to take at least the Required Minimum Distribution. You may take more, but not less. There are some qualified plans with exceptions. Also, ROTH IRAs do not require distribution until after the death of the owner.

Figuring the Required Minimum Distribution

The IRS has tables for figuring your required distribution, with a different table depending on your situation and factors such as the age of your spouse relative to you. The amount of your distribution is figured on the account balance as of December 31st of the prior year, divided by a factor number from your table assigned to your age on your birthday of the current year. For most people the factor divided into the account balance starts at 27.4 and goes down each year as you age.

As an example, if your account balance at the end of the prior year was $601,570 and your factor number for this year is 23.8. Dividing 23.8 into $601,570 means you must take a minimum of $25,276.05 from your retirement account that year, from which you will pay income taxes.

This doesn’t mean you have to spend that money if it, in combination with social security and other investments, means you have more than enough to cover living costs. You can place any excess in savings or other investments. It simply means that you must take that minimum amount or more out so that the IRS has access to tax it.

Each year the factor divided into your remaining balance ratchets down, requiring a slightly smaller required distribution each year. In this way, your retirement account stair steps down year by year until, theoretically, it is emptied by the time you reach what actuarial tables say is the age to which you are expected to live.