This week’s article breaks from the theme of the last few weeks (which were focused more on things to watch out for when building wealth) and shifts focus to a time in your life when you’ve hopefully already accumulated wealth and are ready to live off of it.
If you’re a young reader this might seem far off, but it’s something that’s good to keep in mind throughout your working years, and particularly good to keep in mind when nearing traditional retirement age.
The subject is: Required Minimum Distributions “RMDs”.
RMDs are mandatory withdrawals that the government requires you to take from certain types of retirement accounts (generally the tax-deferred ones like 401k’s and IRA’s) when you reach a certain age (currently 73 years old).
So, why does that matter, you ask - you’re going to be living on the money anyways, why does being required to withdraw it matter?
The answer to that question largely depends on your situation, but the core of the answer is: because of taxes.
Consider this - say you’ve worked hard and saved into retirement accounts your whole career and have managed to save up quite an account balance.
On top of that, you’re going to be able to collect social security, you have a couple rental properties generating income and a healthy brokerage account.
Say you retired 13 years ago at age 60 and lived a modest lifestyle, mostly off of your rental income and a little from your brokerage account - you plan to let your kids inherit your 401k where you’ve been tucking away money all your life.
For the years from age 60-73 your taxable income is almost zero - you’ve retired and no longer have a regular paycheck from your “day job” and your rental income is almost offset by your itemized deductions.
The problem comes at age 73 - the RMDs aren’t just that you have to withdraw some amount from your retirement accounts, you have to withdraw a certain percentage of the account balance each year.
The amount you are required to withdraw each year is determined by a “withdrawal factor” - calculated based on some IRS tables, essentially a number (approximately equal to your life expectancy measured in years remaining in your life) that decreases each year by which you divide your account balance to get the required withdrawal amount (note that because you’re dividing your account balance by this factor and the factor is decreasing each year, your required withdrawal amounts are increasing each year, if your account balance stays the same or grows).
Continuing our example, if you’re 73 at the end of this year (2025) and your 401k balance has grown to $5 million, the approximate amount you’d need to withdraw to avoid penalties is about $189k (a “withdrawal factor” of 26.5 → $189k = $5 million / 26.5.
All of a sudden instead of owing virtually no tax you owe taxes on $189k (or more, depending on your other sources of income).
That sudden increase in your “income” can also mean higher Medicare premiums and other related expenses.
This is a good problem to have, but ultimately it means you’re paying a significant amount in taxes.
So, what’s the point of bringing this up, you ask?
The first point is to bring awareness to the fact that if you’ve saved to tax deferred accounts like a 401k or IRA, the account balance isn’t all yours and you won’t be able to withdraw it as you see fit - make sure you know how much you’ll have to withdraw and when you’ll have to withdraw it (particularly in conjunction with other sources of income) so you aren’t left with too little money to do the things you want due to taxes, higher premiums, etc.
Other reasons to bring it up deal with things you can do to solve the “problem” of RMDs.
One thing you can do to lessen the tax burden you’ll face is to save to post-tax accounts (Roth 401k, Roth IRA, etc.) during your working years.
Another is to employ a strategy known as a Roth Conversion during those years from 60-73 where your income is low (effectively “filling up” lower tax brackets with “income” by transferring money from a tax-deferred account (like a 401k or IRA) to the Roth variant - you’d pay taxes on the money in those lower tax brackets at the time of the transfer and reduce your RMDs when you reach 73 (because your tax-deferred account balance is lower at that point).
Another is to plan where you’ll pull income from in retirement - maybe you have money in a Roth IRA you were planning to use before the money in a 401k; by pulling money from the 401k first, you’ll reduce its balance and reduce the RMDs you’ll face later (Roth accounts aren’t subject to RMDs).
Whatever the case, now you hopefully know a little more about RMDs and can plan for the day when Uncle Sam eventually comes for the taxes you’ve deferred as you’ve saved into retirement accounts during your working years.