RMDs are back: What to know

After a year off, you need to consider how to manage required minimum distributions.

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Key takeaways

  • Congress allowed people to suspend taking required minimum distributions for 2020 as part of COVID-19 relief, but RMDs are back on for 2021.
  • Everyone's RMD situation will be different, but if you don't take your required amount by December 31, you could face IRS penalties.
  • Plan ahead for what you want to do with the money—it may help reduce taxes and increase options for re-investing.

If you took a break from taking required minimum distributions (RMDs) in 2020 thanks to the CARES Act for COVID-19 relief,1 we hope you had a nice vacation and are ready to come back and refresh your retirement income strategy.

Even if you took money out all along for living expenses last year, you'll want to take a look at your overall financial situation to figure out your plan for 2021. And welcome to the club if you're just turning 72, the age where the IRS mandates that you start taking withdrawals from most qualified retirement accounts like IRAs and 401(k)s where you had been saving pre-tax dollars during your working years.2

RMDs can be an important part of your retirement-income plan, but they come with some strict rules about the timing and a formula based on your age for the amount you have to take. If you're still working after turning 72, for instance, you may not have to take RMDs from certain workplace accounts.

You'll want to consider all your options and make sure not to miss any key deadlines that could cost you penalties.

If you have assets that are subject to RMDs, here are 2 key questions to answer that can help you think through how and when to use your RMDs.

1. How should I calculate and withdraw my RMDs?

A financial advisor or tax professional can help you figure out the amount you need to take each year based on your age and the balances at the end of the previous year of your accounts, or you can use our online calculator.

Either way, once you've determined the appropriate amount for each year, you can opt to take the distributions for your RMDs yourself. However, some providers allow you to instead set up automatic withdrawals, based on the same criteria of age and year-end account balances, with the appropriate amounts computed and then withdrawn and sent to you by check or direct deposit on a schedule of your choosing.

"If you automate, you could avoid the potentially costly consequences of forgetting to take your RMD," says Matthew Kenigsberg, vice president of investments and tax at Fidelity.

If you turned off automatic withdrawals in 2020, you may need to turn them back on for 2021.

Regardless of the withdrawal schedule, the deadline is important. The IRS penalty for not taking an RMD, or for taking less than the required amount, is steep: 50% of the amount not taken on time. The deadline to take your first RMD is normally April 1 of the year after you turn 72, and December 31 each following year. Note, however, that if you choose to wait until April 1 of the year after you've turned 72 for your first RMD, it will mean taking 2 RMDs that year, and the additional income could have other tax consequences.

Tip: Many people choose to have taxes withheld from their RMDs, as it is counted as ordinary income. If you choose not to do this, make sure you set aside money to pay the taxes. And be careful—sometimes underwithholding can result in a tax penalty.

2. What should I do with my RMDs?

You have plenty of options for how to use your withdrawals. Among them:

Living expenses
If you plan to use RMDs to pay for current expenses, it often makes sense to align with a budget in retirement. Going through the budgeting process can help you estimate living expenses, manage your cash flow, and determine if you'll need to use your RMDs to fund your retirement lifestyle.

New investments
For some retirees, Social Security benefits and other income may cover your expected expenses. Remember, even though you may not need RMD monies to fund your retirement spending, you're still required to take them out of your applicable retirement accounts. Although your RMD can't be reinvested back into a tax-advantaged retirement account, you can put money into taxable brokerage accounts and then reinvest your RMD proceeds according to a strategy that fits your needs.

Wealth transfer to a loved one
There are several tax-smart ways to pass money to your loved ones. If you'd like to help give someone's education a head start, consider using the money you take for your RMD to fund a 529 college savings account.

Another option is to convert some of your traditional IRA assets to a Roth IRA, which can be inherited without as many tax implications. With this "Roth conversion" strategy, you'll pay income tax on the amount you convert, but you'll no longer have to worry about RMDs on that amount, because RMDs are not required during the lifetime of the original account owner in a Roth IRA.3

Remember, if you're already over 72, you will have to take an RMD for the current tax year before you can convert to a Roth IRA—that is, Roth conversions do not satisfy the RMD requirement, although you can use all or part of the RMD to pay the taxes due from the conversion. On the other hand, if you anticipate that your heirs will be in a much lower tax bracket than your own, it may not make sense to convert.

While distributions from Roth IRAs are generally not subject to federal or state income taxes during the lifetime of the original owner, the balances are still subject to estate tax, so it is important to plan accordingly. Since there are other ways to transfer money to heirs, such as trusts and gifting, consult an estate planning advisor before making any decisions.

Charitable donations
If you have to satisfy an RMD and you would also like to make a gift to charity, then consider a qualified charitable distribution (QCD).

A QCD is a direct transfer of funds from your IRA custodian, payable to a qualified charity. Once you've reached age 72, the QCD amount counts toward your RMD for the year, up to an annual maximum of $100,000. It's not included in your gross income and does not count against the limits on deductions for charitable contributions. These can be significant advantages for certain high-income earners.

Due to changes enacted by the Tax Cuts and Jobs Act, a number of retirees may now choose to take the standard deduction when filing taxes ($12,550 for singles; $25,100 for couples in 2021) rather than itemize. For those people, QCDs may be a useful alternative because they do not rely on itemization as might be the case for other large charitable contributions.

Most importantly, plan ahead

Whichever scenario applies to you, RMDs are likely to play an important role in your finances in retirement. Building a thoughtful retirement income plan can help you use RMDs in the most effective way, and help you reach your important financial goals. At the very least, it's important to spend some time understanding RMDs and your options with a financial and tax professional, to ensure that you are meeting the IRS requirements—and to help avoid a costly tax mistake.

Next steps to consider

Learn more about RMDs

Information about the withdrawals you're required to take.

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