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Know These 3 Facts to Avoid Paying Half Your Retirement Income to the IRS - May 28, 2020

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Neglecting to withdraw a required minimum distribution (RMD) from an IRA by the due date brings about a painful tax code penalty: 50%. Yes, you read that right. If you are supposed to withdraw at least $4,000 and (uh oh!) did not do as such, you have to write the IRS a check for $2,000. Keep in mind that on January 1, 2020, the RMD rules were modified.

Like the majority of investors, you're most likely working on a retirement portfolio that will provide a large enough nest egg to give you a comfortable retirement. Retirement financial planners refer to this as the "accumulation phase." Your goal in this phase is to choose investments with long-term growth potential - for example, a current top ranked dividend stock like Alexandria Real Estate Equities (ARE - Free Report) .

But there is a second phase of retirement planning that gets less attention, even though it's the more enjoyable part. It's the "distribution phase," which simply means spending the assets you've worked so hard to accumulate.

Planning for the distribution phase is the time where you may make decisions about where you'll want to live in retirement, whether you'll want to travel, hobbies you may pursue, and other decisions that will affect your retirement spending.

In addition to these considerations, it is essential to take into account the RMD that applies to most retirement accounts. Basically, this is an IRS requirement that you withdraw a certain amount from your qualified retirement accounts once you reach age 72.

What is the point of this mandatory withdrawal by the IRS? Not surprisingly, it's to be sure that the government gets their tax money. Without the RMD requirement, individuals could live off other income and never pay tax on retirement account gains. That cash could be left to family or friends as an inheritance and the IRS would not receive taxes from it.

The Most Important Things to Know About RMDs

Which types of accounts have RMDs? Qualified retirement accounts such as IRAs, 401(k)s, 457 plans, and other tax-deferred retirement savings plans like a TSP, 403(b), TSA, SEP, or SIMPLE IRA plan require withdrawals in retirement.

When do I have to start taking distributions? For most accounts, you must take your first distribution by April 1 of the year following the calendar year in which you reach age 72. If you retire after that age, you must take your first RMD from your 401(k), profit-sharing, 403(b), or other defined contribution plan by April 1 of the year following the calendar year in which you retire.

Every year after your start date, you are required to take your RMD by December 31. Remember, for Roth IRAs you do not have to take an RMD because you paid taxes before contributing. However, other types of Roth accounts do require RMDs, but you may be able to avoid them (for instance, by rolling your Roth 401(k) into your Roth IRA).

What will happen if I neglect to take my RMD? If you don't take an RMD, or don't take a large enough distribution, you are liable for a 50% tax on the amount that was not withdrawn in time.

How much cash do I need to withdraw? To figure out a particular RMD, you should divide your earlier year's December 31st retirement account balance by a "distribution period" factor dependent on your age.

Example: Ann is 71 and must take her first RMD in the year following the year she reaches age 72. Her year-end IRA balance the prior year was $100,000. Her "distribution period" factor is 27.4. The result of dividing $100,000 by 27.4 is $3,649.63 - the amount that Ann must withdraw for her first RMD.

Learning about the "distribution phase" is just one aspect of preparing for your nest egg years.

To learn more about the tax implications of retirement spending - and much more about retirement planning - download our free guide: Retirement Made Easy.


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