Many federal employees have heard about Required Minimum Distributions (RMDs), and although most will be subject to this rule, few know the details surrounding it.
Since RMDs are such an important factor in retirement planning, this week, we are covering the 5 things you must know about them. So, let’s dive in!
1: What Are RMDs
While tax-advantaged accounts are great since they provide certain tax benefits and often let you defer taxation until your funds are withdrawn in retirement, Uncle Sam doesn’t want you deferring taxation too long. Thus, the IRS imposes RMDs at age 72 (prior to the 2019 SECURE Act RMDs were required after 70 ½).
A required minimum distribution is the amount of money that must be withdrawn annually from the traditional and Roth TSP and the traditional IRA, SEP, or SIMPLE IRA.
Note: RMDs are not required from your TSP if you are still an active federal employee and are not required from Roth IRAs until after the owner’s death.
2: How Are RMD Calculated?
Generally, your RMD is calculated for each account by dividing the balance as of December 31 of last year by your life expectancy factor from the IRS Uniform Lifetime Table based on your birthday in the current year.
For example, let’s say Bob is 74 and single. As of December 31, last year, his TSP balance was $300,000. According to the IRS Uniform Lifetime Table, Bob’s life expectancy factor is 25.5. To calculate his RMD, he divides his balance by 25.5 to get $11,764.71. That is the minimum amount Bob must withdraw from his TSP to satisfy the RMD rules.
Note: The TSP will automatically send you your RMDs if you have not satisfied the requirement by December (TSP will wait until the following March for the first year RMD).
3: May Increase Your Tax Bill
When you consider the fact that we have a progressive tax system, meaning the more money you earn, the higher the tax rate you’ll pay, and that most of your federal retirement income will be taxed at the ordinary tax rates, it’s easy to see how RMDs can push you into a higher tax bracket.
For example, say you’re a single retiree with an ordinary income of $80k in 2022, if your RMD is more than $9,075, it’ll push you into the 24% marginal tax bracket. Meaning, every next dollar taxed at the ordinary income tax rates will be taxed at this higher rate vs. the 22% rate you were paying before the RMD.
For someone who doesn’t need the additional income produced by the RMDs, it can be very frustrating having to pay a higher tax rate on your retirement income.
This is why it’s critical that federal employees not save all their retirement nest egg in the traditional TSP but instead utilize all three account types (tax-deferred, tax-exempt, and taxable) to create tax diversification. You can read more about tax diversification in last week’s article here.
4: First Year Tax Trap
Unlike subsequent RMDs, which must be withdrawn by December 31 every year, your first RMD can be delayed until the April 1 after reaching age 72.
But before you put your checkbook away, this first-year delay may not be as beneficial as it first appears. Why? Remember that every subsequent RMD must be taken by December 31, including your second RMD. So, if you delay your first RMD until year two, you’ll be forced to take two RMDs in one year.
Your first RMD will be due by April 1 of the second year, with the second RMD due by December 31.
And as we previously covered, RMDs can mean a larger tax bill. So, by taking both RMDs in one year, you are more likely to have an unpleasant surprise come the following tax season.
5: Steep Penalty
What happens if you miss the deadline? You could face a steep penalty of 50% of the shortfall. Meaning, if you were supposed to withdraw $11,000 but only withdrew $5,000, your penalty would be $3,000.
Although the TSP atomically distributes your RMDs, you will have to ask your IRA custodian to put your RMDs on autopilot for you.
Final Thoughts
When preparing for retirement, it’s essential to not only plan for the distributions you’ll need for your living expenses but also the Required Minimum Distributions beginning at age 72.
And while most federal employees should allocate some of their retirement savings to the traditional TSP, contributing an excessive amount over your career can lead to a large amount of ordinary income once RMDs kick in, which can mean a large tax bill.
As discussed in last week’s article, utilizing all three tax buckets can help you lower your lifetime tax bill, especially once you reach RMD age.
You should consult a fee-only Certified Financial Planner™ if you need help or aren’t confident in creating your retirement plan.
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2023 Legislative Change Notice
The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.
