Required minimum distributions (RMDs) become a very important point of discussion before the end of the year, and there is a lot that you need to consider. You can take your RMDs monthly, quarterly, and annually.
However, which one is the right choice for you? That’s what we’re going to cover in this post. If you would rather listen to this post, we do have a podcast on this very topic.
What are RMDs?
US tax law requires you to take a certain amount out of your traditional retirement accounts or employer-sponsored retirement plans each year, called a required minimum distribution.
A traditional account is a tax-deferred account, such as your:
- SEP IRA
If you transferred money into these qualified plans and didn’t pay taxes on it, guess what? The IRS will eventually want you to pay your taxes, which is where RMDs come into the equation.
Basically, you need to take out “roughly” 3.5% of your money each year, but there is a more complex calculation involved that we won’t go into with this post. The most important thing is that you’re required to take these distributions even if you don’t need the money.
Whether you’re in your 50s or 65, it’s important to educate yourself on RMDs and what you are required to do. Developing a plan for your RMD is important because you can incorporate a few strategies to lower your distribution requirements, too.
If you reach a certain age, you must take distributions.
In 2020, once you had reached age 70.5, in the calendar year, you would have needed to take distributions. After the Secure Act, this age has changed to age 73 – 75, depending on your birth year. The year you were born dictates this age:
- Born in 1951 – 1959, your RMD age is 73
- Born 1960 and later, your RMD age is 75
In the first year, you can defer your distribution to the next year and take it by April 1st. However, if you do this deferral, you will need to take two distributions, which is uncommon because it will push your tax bracket up.
On a Roth IRA, you have a tax-free bucket that you can use with no RMD requirement during the life of the original owner. Roth accounts are something that we often recommend as a strategy for eliminating or reducing RMDs, but this is something we’ll dive into more shortly.
Quick Note: Inherited IRA accounts work a bit differently. You used to be able to take distributions over a lifetime. Now, the new rule requires you to deplete the entire account over 10 years. There are a few caveats to this rule, but you’ll want to sit down with a financial advisor to discuss these in greater detail. Exceptions do exist for disabled individuals, minor or chronically ill beneficiaries and those who are less than 10 years younger than the original account owner.
Penalty for Not Taking an RMD
We do want to mention that when researching RMDs, you’ll learn that there is a penalty for not taking your distribution once required. The penalty can be 50% of the distribution, which is a lot, but we have never actually seen this applied.
Often, the government will give you a reprieve, but they do want you to take your RMD.
Is It Better to Take Your Required Minimum Distributions Monthly, Quarterly or Annually?
You know what RMDs are and that you can be penalized for not taking them, but one question still remains: at what frequency should you take your RMDs? We’re going to walk you through each of these distribution options.
Everyone has their own line of thinking when it comes to taking their RMDs, and it’s ultimately up to you. Each option has its advantages and disadvantages.
Monthly RMDs: Advantages and Disadvantages
Monthly distributions offer consistent cash flow – just like a paycheck. For example, if you need to take $12,000 per year in distributions, you can rely on $1,000 a month coming into your account.
You also benefit from market volatility.
For example, you are withdrawing the $1,000 when the account is up or down for the month, which can be an advantage or disadvantage. If you have a consistently down market when you’re withdrawing, that can become an issue.
The main advantages are:
- Monthly cash
- Less concern about the market
- Easier to maintain a budget
However, the disadvantages are almost the exact opposite of the advantages. You’re taking money out of the account and missing growth opportunities.
Note on RMD Calculations and Growth Buckets
The IRS calculates your required minimum distribution on the balance of the account at the end of December 31st. If the IRS states that you need to withdraw $12,000 per year, it doesn’t matter if the markets are up or down 100% that year – you still need to take the full distribution.
When offering retirement planning, we often use a bucket strategy.
In this article, we’ll discuss the:
- Income/Safety bucket
- Growth bucket
Why? They offer advantages in a down or up market, helping you mitigate some of the risks your accounts have in retirement.
The income safety bucket often isn’t correlated with the market so:
- It provides income
- Protects against stock market volatility
The growth bucket is, in all essence, money in the stock market. Last year, the market was down 20% or more.
When both buckets work together, it helps safeguard against the market. Money comes from the income bucket and the growth bucket is allowed to grow long-term and mitigate retirement accounts being down.
Income buckets buy us time so that we don’t remove money when an account is down.
During a year like 2022, the growth bucket was allowed to recuperate while still having a steady income from the income bucket. If you have all your money in a growth bucket, it leaves you very little room to mitigate losses.
Note on RMDs and Multiple Accounts
For the sake of simplicity, let’s assume that you have 3 IRA accounts and the government states that you need to take a $12,000 RMD annually. Your distribution can come out of one account, a combination of accounts or all your accounts.
You may have $1 million in an IRA and decide to put 50% in an income bucket and 50% in the growth bucket. You can take all the distribution from the income bucket and let the growth bucket grow.
However, if your money is in a 401(k), there are stricter rules. Money in the 401(k) must come out first if multiple other non-401(k) accounts exist.
You can also put money from a 401(k) into an IRA with different strategies, which may be a better option for you.
Quarterly RMDs: Advantages and Disadvantages
Quarterly distributions are middle-of-the-road. You’re between the monthly and annual distributions, and the advantages and disadvantages are very similar to monthly.
For our clients, it’s always a monthly or annual distribution because many people don’t prefer the quarterly option.
Annual RMDs: Advantages and Disadvantages
Annual distributions are ideal for clients who want to keep their money in the market and let it grow as much as possible. Since the account balance may be higher, you’ll benefit from higher returns.
You can also have a down year where you’ve lost money and now need to take it out of the account when you’re in the negative for the year.
- During up years, you benefit from greater returns
- During down years, you lose some money
What’s best for you? Consider your personal preference and needs. If you need a monthly paycheck, then the monthly RMD is best. However, if you plan to reinvest your RMDs because you don’t need the extra cash flow, it may be better to go with the annual RMDs.
A retirement-focused financial plan is what we recommend to our clients. The rules of RMDs are general, but your case is always going to be unique. Analyzing financial plans in retirement allows us to optimize income and RMD planning.
We can walk you through how this looks, even if you’re not currently a client of ours. You can schedule a 15-minute complimentary call with us that will allow you to discuss your options with us to have a more personal discussion about your RMDs and retirement plan.