What is the Required Minimum Distribution Method
The required minimum distribution method forms the basis for calculating the amount of money the IRS requires retirees to withdraw from their retirement accounts as they age.
BREAKING DOWN Required Minimum Distribution Method
The required minimum distribution method provides an age-based calculation of the amount retirees must withdraw from their accounts each year to deplete their savings within their actuarially expected lifetime. Retirees must withdraw at least this amount from their account each year to avoid adverse tax consequences.
The IRS ensures individuals do not hold tax-advantaged funds in qualified accounts indefinitely by requiring that they withdraw a certain minimum amount of money from their accounts. Under most circumstances, the IRS sets the required beginning date (RBD) on which account holders must begin to take distributions at April 1 following the calendar year in which the account holder turns 70.5.
The IRS calculates the required minimum distribution by establishing a distribution period related to the retiree’s actuarial life expectancy. To arrive at the distribution amount, the individual takes the balance reported in the retirement account on December 31 of the previous year and divides it by the distribution period. The result equals the minimum amount the retiree must withdraw over the course of the current year to avoid penalties.
When retirees take less than the required minimum distribution, the IRS applies a 50-percent excise tax to the difference between the required minimum distribution and the actual amount withdrawn.
Example of a Required Minimum Distribution Calculation
Consider a 73-year-old retiree with a year-end balance of $500,000 in an IRA and suppose the current uniform lifetime table issued by the IRS produced a distribution period of 25 years. To arrive at the required minimum distribution for the current year, the retiree would divide $500,000 by 25, yielding a minimum distribution of $20,000. The IRS does not penalize retirees who withdraw more than their required minimum distribution. The nature of the calculation also means that required minimum distributions change year to year as the reduced life expectancy of the retiree causes the denominator to decrease. Any fluctuations in the account balance due to withdrawals or investment gains or losses would change the numerator in the calculation.
Use in SEPP Plans
For those younger than 59.5 years of age, the IRS provides an option to take distributions from retirement funds while avoiding early withdrawal penalties by placing funds in a substantially equal periodic payment (SEPP) plan. These plans require account holders to choose a method for calculating the amounts they may withdraw penalty free. Under this scenario, the required minimum distribution method provides a variable annual withdrawal amount based upon fluctuations in the account and the account holder’s life expectancy. Account holders may also choose fixed amortization and fixed annuitization methods to determine their allowable amount of penalty-free withdrawals prior to retirement.