The upside to saving for retirement in an IRA or 401(k) plan is getting to enjoy tax breaks on the road to building a nest egg. With a traditional IRA or 401(k), your contributions are made before taxes, thereby shielding some of your income from the IRS. Then investment gains are tax deferred until withdrawals, which are taxable, are taken in retirement.
Meanwhile, Roth IRAs and 401(k)s don’t give you an up-front tax break on your contributions. But what they do offer is tax-free investment gains and tax-free withdrawals during retirement.
The problem with these tax-advantaged retirement plans, though, is that they can be restrictive. For one thing, you can’t take an IRA or 401(k) withdrawal prior to age 59 1/2. If you do, you’ll incur a 10% early-withdrawal penalty (though there are limited exceptions).
But that’s not the worst penalty you might face if you fail to stick to your retirement plan’s rules. In fact, some seniors risk a whopping 50% penalty on some of their money if they don’t act immediately.
Have you taken your first RMD?
While IRAs and 401(k)s offer many tax benefits, they also don’t let you leave your savings alone indefinitely. Rather, you’re eventually forced to take required minimum distributions, or RMDs, from your account come age 72.
Specifically, your first RMD is due by April 1 of the year following the year you turn 72. What this means is that if you turned 72 last year, your first RMD is due by April 1, 2022. And if haven’t taken it yet, you may want to arrange for that withdrawal to happen immediately. If you don’t, you’ll face a 50% penalty on the sum you fail to remove from your retirement plan.
Keep in mind that RMDs used to kick in at an earlier age — 70 1/2. So seniors today actually get a bit more leeway when it comes to starting RMDs. But once you’re on the hook for those withdrawals, it’s important to take them every year. If you don’t, you’re effectively throwing money away.
How RMDs are calculated
The amount of money you’re required to remove from your retirement plan can change from year to year, and it depends on two factors — your life expectancy and your age. Often, your plan custodian or administrator will calculate your RMD for you, or you can otherwise consult your financial advisor or the IRS’s website for help running those numbers.
If you don’t like the idea of having to take RMDs every year, then there’s one solution you can look at — doing a Roth IRA conversion. Roth IRAs are the only tax-advantaged retirement plan that doesn’t impose RMDs. Even Roth 401(k) plans make you take them.
That said, the upside of having a Roth 401(k) is that your RMDs won’t create a tax liability for you, whereas with a traditional IRA or 401(k), you have to pay taxes on your RMDs. To be clear, those taxes are not a penalty — they’re the same taxes that apply to any withdrawal you take from a non-Roth account.
Don’t lose money
If you’ve yet to take your first RMD and it’s due by April 1, drop what you’re doing and figure out the most efficient way to get that money out of your account. And then make sure to keep future RMD deadlines in mind.
The April 1 deadline is a special deadline that applies to your initial RMD only. So if you’re removing funds from your retirement plan now after having turned 72 last year, what you’re really doing is taking your 2021 RMD.
Going forward, RMDs are due by December 31 every year. And so if you’re taking your first RMD now, you’ll need to take your next one — for 2022 — by December 31 of this year. Plan for that accordingly so you’re not pressed for time or caught off guard by a frustratingly high tax bill.
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