If you’ve spent decades saving for retirement, your IRA and 401(k) balances probably feel like a financial safety net. Seeing those accounts grow can be reassuring. But without careful planning, even healthy retirement savings can turn into a ticking tax bomb.
That’s because the Internal Revenue Service (IRS) orders withdrawals from these retirement accounts when you reach age 73 (1). If you have a six- or seven-figure balance, these required minimum distributions, or RMDs, can have a significant impact on your tax bill each year.
Here’s why this tax bomb matters and what you can do to defuse it before it’s too late.
What makes RMDs so frustrating is that they force you to reverse decades of good financial habits. After an entire career of saving, investing and deferring taxes, it can be difficult to switch gears and start selling assets, withdrawing and triggering tax liabilities.
Failing to plan for RMDs can be costly, especially if your retirement accounts have grown substantially.
RMDs are calculated using your age and your account balance as of December 31 of the previous year. According to Fidelity, the IRS applies a life expectancy factor to determine how much you should withdraw in a year (2).
For example, if your account balance is $100,000 the year before you turn 73, the IRS uses a life expectancy factor of 26.5. This results in a required withdrawal of approximately $3,773.60. With a $500,000 balance, the RMD goes to about $18,867.90.
Higher balances trigger larger withdrawals, which can easily push you into a higher tax bracket. That extra income, combined with other sources, can increase taxes on Social Security benefits or raise Medicare premiums through income-related monthly adjustment amounts (3).
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If you fail to withdraw the required amount on time, the penalty stands. The IRS may charge you 25% of the amount you withdraw. Many investment platforms now offer tools that automate RMDs, helping retirees avoid missed deadlines and complicated calculations (4).
