Rookie Retirement Error: Taking Late RMDs

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If you’re an investor of a certain age, here’s a gentle reminder: don’t leave your RMD to the last minute.

RMD is short for required minimum distribution, an annual withdrawal from a traditional IRA, 401(k) or similar retirement plan. RMDs must begin after the investor turns 70½. They have to be done by the end of the year, except in the year you turn 70½, when the deadline is the April 1 the following year.

Some investors could overlook this requirement because it was waived last year to make life a little easier in the recession. But that was just a one-year deal. Forgetting an RMD is a big mistake, triggering a penalty of 50% of the amount that should have been taken.

Although your retirement accounts could rise or fall by the year-end deadline, that won’t affect the required distribution because it is based on values on Dec. 31, 2009. But it can pay to take the RMD before year-end if you plan to reinvest the money and see a promising opportunity. So here’s a reminder of a few RMD basics.

First, why do so many investors consider this a burdensome requirement? It’s because standard investing strategy calls for leaving money in tax-favored plans like IRAs and 401(k)s for as long as possible, allowing tax deferral to boost compounding. Like all withdrawals from these accounts, RMDs are subject to income tax.

A $10,000 withdrawal could trigger a $2,500 tax for someone in the 25% tax bracket. (There’s no RMD for Roth IRAs and Roth 401(k)s, because their withdrawals are tax-free.)

Basically, the required amount is figured by dividing the account’s value on the previous Dec. 31 by the investor’s life expectancy according to government tables. If you were expected to live 20 more years, you’d have to withdraw one twentieth, or 5%. For a $100,000 account, you’d have to take out $5,000, and pay a $1,250 tax at the 25% rate.

The next year you would use the account value on the next Dec. 31, dividing by 19, and so on. (Actually, your life expectancy does not fall a full 12 months every year, since each additional year means you’ve escaped all the things that could have killed you.)

Since many investors have more than one retirement account, the calculations can be a bit complicated. If you had three IRA accounts, for instance, you would figure an RMD for each, but then could make the withdrawal any way you choose. The total amount required could come from one account or be divided any way you wanted among two or three.

If you also had a 401(k), you’d calculate the required withdrawal the same way. But the entire amount would have to come from the 401(k), which cannot be lumped in with the IRAs.

How to you figure your life expectancy? The government has already done it. They’re in the appendix to IRS Publication 590, which has all the RMD details. Also look at this IRS FAQ.

Your brokerage, bank or mutual fund company probably has publications and online worksheets for figuring the RMD.

Of course, the government requires that you take an RMD but doesn’t care what you do with the money. You can spend it or reinvest it. If you reinvest, be sure you have cash set aside to pay the tax.

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