Calculating Required Minimum Distributions From a Tax-Qualified Retirement Account

income taxMy Comments: OK, I’m not a CPA and I’m talking about a tax matter. Please don’t call the FBI on me. If you have money in an account and it it got there before income taxes were applied to the money you earned, it’s known as a “qualified account”. Simply put, it “qualified” for special treatment by the IRS.

The offset to this is that in exchange for you NOT treating that money as taxable when you earned it, the IRA has imposed rules saying WHEN you must pay income taxes on that money. The incentive for all this is to encourage people to set aside money while they are working so they will have more when they are NOT working, ie retirement.

The Required Minimum Distribution (RMD) rules come into play when you reach age 70½. The requirement is you must start taking money out of those accounts or there is a disincentive that will cause you financial pain.

By Sean Williams | October 15, 2016

The United States may have the highest GDP of any country on the planet, and Americans may enjoy an above-average standard of living, but that doesn’t mean we have the best financial habits.

According to St. Louis Federal Reserve, the U.S. personal household savings rate in August was just 5.7%. This is well below most developed countries, about half the rate of what Americans were saving 50 years ago, and markedly lower than the 10% to 15% figure that financial advisors recommend consumers save. Per GoBankingRates’ latest survey, 62% of Americans have less than $1,000 in savings.

Yet here’s the irony of these figures: Americans have a bounty of tax-advantaged retirement options at their fingertips practically begging to be used. Three of the most common of these tools are the Traditional IRA, Roth IRA, and employer-sponsored 401(k).

Americans have an abundance of tax-advantaged retirement options

Of the three, the Roth IRA has probably witnessed the strongest growth this decade. Beginning in 2010, lawmakers altered the Roth IRA conversion rules. This allowed people who had previously been unable to contribute to a Roth because they earned too much to make the switch. Though a Roth IRA doesn’t provide an upfront tax benefit, it does allow a persons’ money to grow completely tax-free for life, so long as no unqualified withdrawals are made prior to age 59 1/2. It’s this potential for tax-free income during retirement, as well as the financial flexibility afforded by the Roth IRA — contributions (not to be confused with investment gains) can be withdrawn at any time, and for any reason, without tax or penalty — that’s made it such a popular retirement option.

But, no retirement plan has more active accounts than a 401(k), and the number of Traditional IRA accounts still outnumbers Roth IRAs. Both the Traditional IRA, which allows for a maximum contribution of $5,500 annual for people aged 49 and under and $6,500 for seniors aged 50 and up, and 401(k), which allows for contributions of up to $18,000 and $24,000, respectively, among those same age ranges as the Traditional IRA, are tax-deferred investment tools. This means that they can help reduce your taxable income in the current tax year, and that your investments can grow on a tax-deferred basis. However, once you retire, you’ll be required to pay ordinary income tax on the money you withdraw from a Traditional IRA and/or 401(k).

How to calculate your required minimum distribution

There’s another factor retirees should probably acquaint themselves with if they plan on utilizing a 401(k) plan or Traditional IRA during retirement: both plans have required minimum distributions, or RMDs. In plain terms, there’s a formula that determines how much money you’ll be required to withdraw from these retirement plans every year. Failing to do so could result in hefty tax penalties of up to 50% on the amount you should have withdrawn.

How do you calculate your RMD? Let’s take a closer look.

In order to calculate your RMD, you’ll need to know three figures:
• The age you’ll turn in 2016.
• The applicable divisor associated with that age (which we’ll get to in a moment).
• The monetary value of your 401(k) or Traditional IRA. ( as of 12/31/XX of the year immediately preceding the year for which you are making the RMD calculation)

In order to locate your applicable age-dependent divisor, use the following table:

As you can see, the applicable divisor decreases over time, requiring you to make larger distributions as you age.

As an example, a Government Accountability Office study in 2015 found that persons aged 65 to 74 had an average of $148,000 in retirement savings. Assuming you’ll turn age 70 in 2016, the divisor you’d use is 27.4 based on the table above. In order to determine your RMD in a given year you’ll divide your current account balance into the divisor (i.e., $148,000/27.4). In this instance your RMD in 2016 would be $5,401. Failing to withdraw this amount from your 401(k) or Traditional IRA could lead to a 50% penalty.

Investing shouldn’t stop when you retire

However, there’s an oft-overlooked point about RMDs: continued investment in a 401(k) or Traditional IRA could still lead to portfolio growth and/or RMD replacement well after your 70th birthday. Below is a table detailing the required rate of return you’d need in your 401(k) or Traditional IRA to maintain your account balance following your withdrawal. These calculations are provided by the Financial Industry Regulation Authority, and they assume beginning-of-the-year distributions. (Note: I’ve not included this table here. If you need to see it, go HERE )

What you’ll note is that in the 14 years between ages 70 and 84 the required rate of return to maintain your account balance from one year to the next is lower than 7%. The reason this figure is of such importance is that historically the stock market has returned 7% per year, inclusive of dividend reinvestment.

It’s impossible to predict what the stock market will do in the short-term, but over the long run the stock market tends to head higher, as the data clearly shows. What this implies is that if retirees continue to invest for their future, they may be able to hold off on seeing any real depletion in their retirement accounts until their mid-80s. Again, this makes some very broad assumptions that the stock market continues to perform as it has in the past; but the data is suggesting that continuing to invest could be of great benefit to seniors and their tax-advantaged retirement accounts.

(Note: there is an effective RMD calculator to be found HERE: )