Do you have a retirement account you’ve invested in throughout your life? Once you leave the workforce and start drawing money from it, you’re almost certain to encounter required minimum distributions, or RMDs. These withdrawal rules can affect the amount of money you’ll have available to live on during retirement, so it’s important to understand what they are and how they work.
The IRS regularly publishes information in various tables to help employers determine RMDs. You may have seen the news that the IRS table for the required minimum distribution on retirement accounts has been updated for 2022. Whether you’re already retired or aren’t looking to retire for several decades, this may change your retirement saving strategy. To get started find out what the new tables are and how they might affect you.
What Is an RMD?
This term applies to retirement accounts, such as 401Ks and IRAs. When you invest money in a retirement account, the best practice is to leave that money in the account for as long as possible. Your investment becomes more valuable when you allow it to grow longer. However, you can’t leave your money in a retirement account forever.
Some retirement accounts don’t require you to pay taxes on the earnings you make off of your contributions. The IRS gives you this incentive to save for retirement for the sole purpose of using that money during retirement. While you certainly want to allow your investment to grow as long as possible, the IRS expects you to use that money at some point. That’s where RMDs come in.
When you’re ready to start using your retirement savings, you withdraw your RMD from your retirement account each year. You can choose what year of retirement you start withdrawing money from your retirement account. Rather than cashing out your retirement account in one lump sum, the IRS uses RMDs to suggest what amount of money is reasonable for you to withdraw each year so you can have some money left over for the remainder of your life in retirement. Everyone is required to start withdrawing the RMD each year in the year they turn 72. In the tax year you withdraw your RMD (or a greater amount) from your retirement account, that money counts as income.
How Do RMDs Work?
Essentially, the IRS won’t allow you to keep earning money tax-free in a retirement account without ever making withdrawals from it. You’ll have to use that money for living in retirement at some point in time. Otherwise, the IRS wouldn’t allow you to earn money without paying taxes on it each year.
If you’re at an age at which you’re obligated to withdraw the RMD but don’t do so in a particular year, you’ll be taxed as if you did withdraw 50% of your RMD. Some people take a calculated risk and decide that paying taxes on 50% of the RMD they didn’t take is better than taking money out of the account. For the average person, it’s more important to have good cash flow during retirement and stay in the good graces of the IRS.
How Do RMD Tables Work?
The IRS creates RMD tables based on the average life expectancies of people in the U.S. For each age on the table, there’s a number based on the number of years the average person at that age is expected to continue living. You divide the total amount of money in your retirement account by that number to calculate your RMD for that year.
For example, suppose the average life expectancy is 100. That means a 65-year-old person is expected to live 35 more years. The IRS Uniform Lifetime Table displays the number 35 next to the age 65. That means a 65-year-old retiree who’s ready to live on money from their retirement accounts has an RMD for that year of 1/35th of the sum within their retirement account. Suppose this 65-year-old retiree has $1,000,000 in an IRA. Then, their RMD for their 65th year of life is $1,000,000 divided by 35, or $28,571.
The RMD is just a minimum. If the retiree needs more than $28,571 to live on for the year, they’re free to withdraw more than the RMD from their retirement account each year.
What Is the New RMD Table for 2022?
The key change to the IRS Uniform Lifetime Table for 2022 is an update on the life expectancy of retirees. According to the data set that the IRS used, modern retirees are living longer, so the numbers on the table have been changed to reflect that.
Because the tables try to make retirement savings last as living expenses for a longer lifespan, the RMDs for each year are lower. The amount of impact that has on your financial planning depends on what your primary sources of retirement income will be.
Remember that an RMD is just a minimum. If you need more than the RMD to live on, there’s no penalty for withdrawing more of your savings in a given year. However, if you have much more retirement savings available than you can use in a year, the 2022 RMD table changes are great for you. If you’re still in the process of planning for retirement and RMDs are a key piece of your financial plan, this may be an excellent time to work with your financial adviser to plan how the adjustment impacts your financial forecast. If you have a retirement savings plan, you should continue to follow it.
Suppose you’re a retiree who only takes out the RMD yearly to avoid tax penalties, and you don’t need the RMD to live on. If you can withdraw less money from your retirement accounts each year, you have more money with which to continue earning more income through investments in your accounts. All those investment earnings are tax-free as long as your money can sit in your retirement accounts.
This big change to the 2022 RMD tables allows some retirees to keep reaping the tax incentives of a retirement account longer. However, the rising cost of living, and the fact that more people are living longer and requiring more medical care, may have retirees withdrawing more than their RMD each year to keep up with inflation.