80% of retirees get the RMD rule wrong ‘out of fear’ – and it could cost them thousands in lost income.
Most of us have the same goal: we will spend our working years putting money away so that we have enough money saved for a comfortable retirement.
This dedication to saving means we may have to make sacrifices as we look forward to future rewards. So, why are so many retirees tightening their belts further and reducing their retirement savings?
Based on research conducted in the 1950s by Nobel Prize-winning economist Franco Modigliani and his student, Richard Brumberg, many economists argue that we base our spending and saving decisions on our beliefs about income and living costs – and therefore aim to maintain our level of money. consumption is stable throughout our lives.
When we are young, we often have little income and may take on a lot of debt, such as mortgages, in the belief that we can pay it off with a higher income later in life. As our income increases, we start saving to maintain our current level of spending by using these savings when our income decreases in retirement.
In fact, people tend to reduce their variable spending in retirement, a phenomenon known as the “retirement spending paradox.” This can be by choice or by necessity.
For example, 32% of retirees are “sure they haven’t saved enough” and 68% are worried they will outlive their assets, according to Schroders 2024 US Retirement Survey. Whether they’ve saved enough or not, they’re worried about inflation, health care costs, and falling markets.
It’s no surprise that retirees are careful about how they spend their money. But this leads more than 80% of retirees to make the mistake of only taking their required minimum distributions (RMDs) from the accounts they need.
Doing this can be costly for retirees because it may mean they limit their income when they are in the active phase of retirement and may enjoy it more. Then they get more income when they slow down and may have less need for it.
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An RMD is an annual withdrawal from a pre-tax retirement account, which is mandatory under Internal Revenue Service (IRS) rules. These include 401(k)s, 403(b)s, 457s, government TSPs, and traditional IRA accounts.
You are required to start taking RMDs by Dec. 31 of each year, from the year you turn 73. There is an exception in the first year that allows you to take your first RMD on April 1 of the year following the year you turn 73, but this will require you to take two RMDs that year. If you don’t take your RMD, you could face a tax penalty of up to 25% of the RMD that should have been paid.
RMDs are calculated by dividing your account balance as of Dec. 31 of the previous year’s life expectancy based on tables posted on the IRS website.
For example, if you are 77 years old, married (to someone 10 years younger than you) and your balance as of December 31 of last year was $1,000,000, then dividing $1,000,000 by 22.9 (your life expectancy), gives you This year’s RMD is $43,668.
If you earn even an average annual return of 4.6% on your portfolio, you will still have $1,000,000 at the end of the next year, only this time your life expectancy is only 22.0, so your RMD is approximately $45,454. .
If your returns remain reasonable, you’ll take out part or all of your withdrawals each year, potentially leaving you with a large account balance and large withdrawals in later years that you may not be able to enjoy as much.
Of course, this can be a good thing if you want to leave something for your beneficiaries, but if not, you could be leaving thousands of dollars on the table – and possibly enjoying your retirement a lot more.
If you don’t need money from your RMD, you can explore options like qualified charitable distributions (QCDs), which allow you to donate your RMD directly to a charity. RMDs are generally taxed as income, but contributions are not.
If you feel you don’t need the money now, but may need it later — such as increased medical expenses — you may want to consider using your IRA or retirement plan funds to purchase a long-term fixed term contract (QLAC). Payments from a QLAC can begin as late as age 85 and are generally not in the RMD requirements until then.
If you’re worried about RMDs, you might consider putting money into a Roth account. You will pay taxes during the rollover, but there are no RMDs for Roth accounts and, subject to certain conditions, withdrawals are tax-free.
Your total withdrawal amount is probably not the same as your RMD — and it’s likely to change over time — so it’s a good idea to consult with a financial advisor to help you determine the amount that’s right for you.
This article provides information only and should not be construed as advice. Offered without warranty of any kind.
