Individual retirement accounts are self-managed financial accounts that offer tax benefits. Traditional IRAs let you deduct contributions on your income tax return if you don't have access to a retirement plan at work, or you meet certain income requirements. Taxes are not due on traditional IRAs until you take money out during retirement, but the government requires you to start making withdrawals at age 70 1/2.
Required Minimum Distribution Basics
Required withdrawals from IRAs and other types of retirement accounts are called "Required Minimum Distributions," or RMDs. RMD laws require you to start withdrawing funds from a traditional IRA by April 15 of the year after the year in which you turn 70 1/2. You must make required withdrawals from a traditional IRA, even if you work past age 70 1/2 and you cannot contribute more money to a traditional IRA after age 70 1/2. Roth IRAs are an alternative to traditional IRAs where contributions are not tax deductible, but withdrawals are not subject to income tax. Roth IRAs do not have required distributions and you can continue contributing to a Roth IRA as long as you wish.
Required Distribution Amount
The amount you have to withdraw for an RMD depends on your IRA balance and your age at the end of the year. The required withdrawal for a given year equals your total account balance on Dec. 31 of the previous year, divided by a "distribution period," which is a fixed number based on your age. The distribution period is 27.4 at age 70 and decreases for every subsequent year to a minimum of 1.9 for those aged 115 and over. For example, if your IRA balance is $50,000 and you are age 70 at the end of the year in which you turn 70 1/2, you have to withdraw $50,000 divided by 27.4, or $1,824.82.
Required Distribution Penalty
If you fail to make a required withdrawal, the government imposes a harsh tax penalty. According to the IRS, you face a 50 percent tax penalty on RMDs that you don’t make. For instance, if you are required to withdraw $2,000, but you only take out $1,500, the remaining $500 that you did not withdraw is subject to a 50 percent tax penalty.
Since the distribution period for RMDs goes down as you get older, you have to withdraw a larger percentage of your total IRA balance each year. At age 70, you only have to take out about 3.65 percent of your balance as a required withdrawal. Following the earlier example, if you are 70 and have a balance of $50,000, then your RMD is $50,000 times 3.65 percent, or $1,825 -- roughly the same amount you arrived at in Section 2. At age 80 the RMD amounts to 5.35 percent of your balance and it increases to 8.77 percent by age 90. If your IRA investments produce returns that exceed your RMDs, your account balance could increase after age 70 1/2 despite having to make RMDs.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.