If you saved $2.5 million in your traditional 401(k) or IRA, you’re probably wondering how much you’ll need to withdraw due to required minimum distributions (RMDs) and the impact they’ll have on your retirement benefits.
After all, they’re required of everyone with a traditional 401(k) and IRA once they turn 73. It’s a way for the Internal Revenue Service to get paid for all the tax-free contributions you made to your retirement account during your working years.
But those RMDs can have ramifications if they’re large enough. They can push you into a higher income bracket, increase your Medicare premiums, or force you to pay taxes on a portion of your Social Security benefits. You also have to withdraw money that you may not need.
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If you take out too much, it means less money to spend later or leave to your heirs. Take out too little, and you could be on the hook for as much as 25% in penalties. If that sounds like a lot, consider that penalties were as high as 50% before the passage of Secure 2.0. A penalty drops all the way down to 10% if you correct your RMD mistake within two years.
Here’s a look at what RMDs you’ll owe between ages 73 and 85 if you have $2.5 million saved. (We also looked at what you’ll owe in RMDs when you have $1 million and $5 million saved.)
|
Age |
Life Expectancy Factor |
RMD |
|
73 |
26.5 |
$94,340 |
|
75 |
24.6 |
$101,626 |
|
80 |
20.2 |
$123,762 |
|
85 |
16 |
$156,250 |
Calculating your RMDs
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When it comes to calculating your RMDs, it’s a straightforward formula that most financial advisers follow. Account Balance/Life Expectancy Factor = RMD
Your account balance is determined as of December 31st of the previous year, while your life expectancy factor is drawn from the IRS Uniform Lifetime Table, which is the go-to chart that the vast majority of retirees are required to use, regardless of their actual health status.
Keep in mind that your RMDs aren’t static and will change as you age. The older you get, the lower your life expectancy factor is and the more you have to pay in RMDs.
Because the government assumes that as you age, you have less time left to spend your wealth, it forces you to withdraw a larger percentage of your remaining savings with each passing year.
Lower your RMDs with Roth conversions
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One tax-smart way to lower your RMDs is with a Roth conversion. This involves moving money from a traditional pre-tax account — such as an IRA, 401(K), 403(b), or 457(b) — into a Roth IRA, paying taxes on the transition in exchange for tax-free growth. Roth IRAs have no RMDs and allow tax-free withdrawals after five years and age 59-1/2.
The catch? You owe ordinary income tax on the converted amount, which can push you into a higher tax bracket. To avoid this, you can spread your conversions over several years, converting only enough to reach the top of your current bracket.
If you are 73 or older, do this…
-Take your annual RMD first, as the IRS does not allow you to convert RMD funds into a Roth account.
-Convert remaining traditional IRA funds up to the top of your current tax bracket to shrink the size of your future RMD obligations. You should do this annually to shrink your RMDs.
-Pay the conversion tax bill using cash from a non-retirement account to maximize the amount of money left growing tax-free inside the Roth.
If you are under 73, do this…
-Maximize your conversions now, completing them before RMDs kick in.
-Target the low-income years between your retirement date and when your RMDs start for the conversions.
-Keep in mind that starting in 2033, if you were born in 1960 or later, your RMD age will be 75, giving you even more time for Roth conversions.
RMDs don’t have to be a headache
You don’t have to fear RMDs, regardless of the amount you have saved. While you can’t avoid them completely, you can lower the annual amount.
The first step is knowing how much you need to withdraw. Armed with that information, you can plan strategies to lower your tax bill, such as converting money to a Roth IRA.