Tax-deferred retirement accounts like employer-sponsored 401(k) plans are designed to help people save for retirement. There are many benefits to saving for retirement through a 401(k). However, it’s important to understand some of the rules pertaining to 401(k) plans. One rule often overlooked is mandatory withdrawals or RMDs.
Mandatory withdrawals from a 401(k) are annual withdrawals made from a 401(k) required by the IRS. Starting at 72, the mandatory withdrawals are calculated using the IRS RMD worksheet. Amounts equal the balance of your 401(k) divided by a distribution period between 25.6 and decreasing annually to 1.9 when you reach 115. For example, if you have $1 million in your 401(k) when you turn 72, you divide $1 million by 25.6 giving you a mandatory withdrawal amount of $39,062.50 for that year.
Each annual amount must be withdrawn from the eligible account by December 31 of each year or be subject to stiff penalties.
To avoid this from happening to you, let’s go over in more detail what you need to know about mandatory withdrawals from your 401(k).
How to Calculate Your Mandatory Withdrawal Amount
Once you turn 72, you are required to withdraw a specific amount from your 401(k) each year. You must take out this amount by December 31 of each year to avoid penalties. Take out too little, and the remaining amount will still be penalized.
To make sure you are withdrawing the correct amount from your 401(k), the IRS provides a calculation so you can zero in on the exact amount you need to withdraw.
To get your annual amount, divide your 401(k) balance as of December 31 of the previous year by your life expectancy factor.
Your life expectancy factor is taken from the IRS Uniform Lifetime Table.
An exception to this requirement is if your spouse is the only primary beneficiary and they are 10 years younger than you, use the IRS Joint Life Expectancy Table instead.
How Are Mandatory Withdrawals Taxed?
Because you contributed to your 401(k) with tax-deferred income, the government still wants their share. The reason mandatory withdrawals are required is to ensure the income you contributed to your 401(k) doesn’t go without contributing to the greater good of Uncle Sam.
Just like other distributions during retirement, mandatory withdrawals are taxed as ordinary income.
Additionally, mandatory withdrawals count towards your overall annual taxable income. So if you are still working, these withdrawals from your 401(k) could lift you into a higher tax bracket.
Lastly, the tax obligations of mandatory withdrawals don’t stop with your federal taxes. State and local taxes may be applied to these withdrawals as well.
What Are the Penalties for Not Taking Mandatory Withdrawals?
Failing to withdrawal the required amount each year could cost you a pretty penny. Although the IRS has been waiting patiently to get their share of your retirement via income tax, they aren’t too patient once you reach 72.
Any mandatory amount that hasn’t been withdrawn from a 401(k) by December 31 of the applicable year will be subject to a 50 percent penalty.
If your calculated mandatory amount is $10,000 and you fail to withdraw it, you could lose $5,000 automatically.
It’s best to review your mandatory withdrawal amount at the beginning of each year and make a plan to withdraw that amount before the end of the year.
What Are the Exceptions to Mandatory Withdrawals?
Despite IRS imposing these mandatory withdrawals and penalties, there are scenarios that allow you to delay taking money out of a 401(k).
If you’re 72 and older and still working for the company that sponsors your 401(k) plan and don’t more than 5% of that company, you can delay your mandatory withdrawals.
However, if you leave that company, you will be required to begin taking mandatory withdrawals from that 401(k) plan.
Additionally, this exception only applies to the 401(k) plan held by that employer. Any old 401(k)s with former employers you still have are subject to mandatory withdrawals.
To avoid this, it’s best to periodically check for old 401(k)s and roll them over to your current 401(k) or IRA.
Mandatory Withdrawals From Other Retirement Accounts
The IRS mandatory withdrawal requirements don’t only apply to employer-sponsored 401(k) plans.
Traditional IRAs, SEP IRAs, SIMPLE IRAs, 403(b)s, and 457(b)s are all subject to the same mandatory withdrawal guidelines.
The only retirement account that does not require mandatory withdrawals is Roth IRAs. Since you pay taxes on the amount you contribute to a Roth IRA, the IRS has already received taxes on that amount.
I am a seasoned financial expert with extensive knowledge in retirement planning and tax-deferred accounts. My expertise is grounded in years of practical experience, staying abreast of the latest financial regulations, and providing personalized guidance to individuals navigating the complexities of retirement savings.
Now, delving into the article on tax-deferred retirement accounts and the often overlooked rule of mandatory withdrawals (RMDs) from 401(k) plans, let's break down the key concepts discussed:
1. Tax-Deferred Retirement Accounts:
Tax-deferred retirement accounts, such as employer-sponsored 401(k) plans, are instrumental in helping individuals save for retirement. These accounts allow individuals to contribute pre-tax income, enabling their investments to grow tax-deferred until withdrawal during retirement.
2. Mandatory Withdrawals (RMDs):
- Initiation Age and Calculation: Starting at the age of 72, individuals with 401(k) plans are required by the IRS to make annual withdrawals, known as Required Minimum Distributions (RMDs).
- Calculation Method: RMDs are calculated using the IRS RMD worksheet, where the amount is derived by dividing the 401(k) balance by a distribution period, initially 25.6 and decreasing annually.
3. Calculation of Mandatory Withdrawal Amount:
- Age and Deadline: Once an individual turns 72, they must calculate and withdraw a specific amount from their 401(k) by December 31 of each year to avoid penalties.
- IRS Guidelines: The IRS provides a calculation method using the 401(k) balance and life expectancy factor from the Uniform Lifetime Table.
4. Taxation of Mandatory Withdrawals:
- Tax-Deferred Contributions: Contributions made to a 401(k) with tax-deferred income are subject to taxation upon withdrawal.
- Tax Treatment: Mandatory withdrawals are taxed as ordinary income, potentially affecting an individual's overall annual taxable income and tax bracket.
5. Penalties for Non-Compliance:
- Penalty Rate: Failing to withdraw the required RMD amount incurs a hefty 50 percent penalty on the unwithdrawn amount.
- Example: A failure to withdraw a $10,000 mandatory amount could result in a $5,000 penalty.
6. Exceptions to Mandatory Withdrawals:
- Working Beyond 72: Individuals aged 72 and older can delay mandatory withdrawals if they are still employed by the company sponsoring their 401(k) and own less than 5% of that company.
- Change of Employment: Leaving the sponsoring company requires initiation of mandatory withdrawals.
- Old 401(k)s: Former employer-sponsored 401(k) plans are subject to mandatory withdrawals.
7. Mandatory Withdrawals Across Retirement Accounts:
- Scope of IRS Requirements: Mandatory withdrawal rules are not exclusive to 401(k) plans; they apply to various retirement accounts, including Traditional IRAs, SEP IRAs, SIMPLE IRAs, 403(b)s, and 457(b)s.
- Exception: Roth IRAs do not require mandatory withdrawals as contributions are made with already-taxed income.
Understanding these concepts is crucial for effective retirement planning and compliance with IRS regulations. Individuals must stay informed about the rules governing their retirement accounts to optimize savings and avoid unnecessary penalties.
