How Distributions Work in Retirement (And How They Can Hurt You!)

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When I started my career in financial advising, I was clearly getting into a fairly complex business. It’s not so much because of the nature of investing and finances in and of themselves, but rather the regulation and rules that dictate what you can or must do, when, and how often.

Few things can be more complicated than taking money from your retirement account. The rules can be very particular and breaking them can be extremely costly.

Following is an explanation of some of the fundamental retirement distribution rules you should be aware of as you think about taking money from your 401(k) or IRA.

Why Retirement Distribution Rules Exist

Why are there rules around when and how you can withdraw money from your retirement account? At the heart of the matter is the fact that most retirement accounts have certain tax advantages which work in your favor for your entire working career.

First, you’ve been allowed to make pre-tax or tax deductible contributions to your 401(k) or IRA. This means that taxable income that the government would have otherwise had in their pockets actually stayed in yours.

Second, since you were able to keep that money in your own pocket you probably chose to invest in a variety of stocks, bonds, or mutual funds in your retirement account. This gave you more money to invest and more money to grow.

Third, you were not taxed on the money growing over time. It was tax-deferred. Every time your mutual fund paid a dividend or capital gain the government couldn’t go after it (like they can in other account types). This allowed for even greater growth as your earnings could create earnings of their own through compound interest.

By the time you retire the IRS is ready to get what’s theirs, and there are strict rules for doing so, and huge penalties if you don’t.

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The Basic Retirement Distribution Rules

As I mentioned earlier, taking your retirement money can be complicated, but there are some fairly simple rules that apply in almost every case for 401(k)s and IRAs.

Withdrawals Can Begin as Early as Age 59 ½

The age feels a little arbitrary, but such it is. The IRS rule is that you need to wait until at least age 59 ½ before taking money from your retirement account. Why do they care? Since most 401(k) and IRA withdrawals are taxable, doesn’t this mean the IRS gets their money sooner?

There’s a bit of a balance here. They do want their money eventually, but they also want to make sure you’re using your retirement account for its intended purpose: RETIREMENT. If money is coming out before 59 ½ the perception is you’re probably spending it on something else besides retirement expenses. As a result, you’ll be subject to a 10% penalty for most early withdrawals before this age.

Withdrawals Must Begin by Age 70 ½

Eventually, Uncle Sam wants what’s his and withdrawals from your 401(k) or IRA need to begin. This is by the age of 70 ½ (though in the year you turn 70 ½ you’re allowed to wait until April 1 of the following year).

Allow this fact to sink in for a minute. If you started investing regularly at age 30 and made your first withdrawal at age 70 ½, that’s over 40 years of tax-deferred, compounding growth that the IRS hasn’t touched! Even though the IRS is gonna get their taxes, they’ve given you a huge advantage of tax-deferred growth for decades!

Even though the IRS is gonna get their taxes, they’ve given you a huge advantage of tax-deferred growth for decades!

For most families, the decision to take withdrawals from their retirement account has already happened by this time, since most workers tend to retire before this age. Still this rule is important to keep in mind for our next and final point…

Withdrawals Must be for a Minimum Amount

To ensure that you eventually pay taxes on a reasonable portion of your tax-deferred contributions and growth, IRS rules also require you to make withdrawals for a minimum amount each and every year by age 70 ½. These are commonly known as Required Minimum Distributions, or RMDs. No minimum amount is required before this age.

Let’s spend a moment on the topic of how RMDs are determined.

How Required Minimum Distributions Work

To help enforce the minimum distribution rules, IRA trustees are required to provide notice to you when you have a RMD coming due. Interestingly, this requirement does not apply to your 401(k) plan trustee, so you’ll need to be mindful of when your RMD is coming due if you are approaching age 70 and have not yet started your distributions.

The minimum distribution amount is determined by taking the retirement account balance and dividing it by a factor called the “distribution period.” This value is based on the age of you, the participant. You can download a copy of it here.

 The IRS's Required Minimum Distribution (Uniform Lifetime) Table

The IRS's Required Minimum Distribution (Uniform Lifetime) Table

Example

Suppose it’s January of 2018 and you’re 71 years old. As of December 31, 2017 you had a $100,000 IRA balance. Your required minimum distribution would be $100,000 / 26.5 or $3,773.

As you probably noticed, the distribution period decreases each year meaning your RMD tends to increase as you age.

Example

Suppose it’s January 2019, you’re 72, and your IRA balance is now $98,000. Your required minimum distribution would be $98,000 / 25.6 or $3,828.

A Steep Penalty for Not Taking Your Minimum

The IRS has a nasty penalty for failing to take your minimum distribution. If minimum distributions do not happen on time, the participant is required to pay a 50 percent excise tax on the amount between what was actually distributed and what was required to be distributed.

Example

Suppose your required minimum distribution for this year is $5,000, but instead of taking the full $5,000 you only take $2,500. You would be required to pay a 50 percent tax on the difference of the required amount ($5,000) and the amount you actually withdrew ($2,500). $5,000 - $2,500 is $2,500 so your excise tax would be $1,250.

If minimum distributions do not happen on time, the participant is required to pay a 50 percent excise tax…!

I hope this article has helped you understand some of the basic mechanics of Required Minimum Distribution rules and the steep penalties if you don’t follow them.

In a future post I’ll drill deeper into this topic and explain how the RMD rules can be slightly different when comparing 401(k)s, Traditional IRAs, and Roth IRAs.

In the meantime, if there’s a question you have about RMDs feel free to let me know.