Tax-advantaged retirement accounts are wonderful financial vehicles that can help you build wealth and plan for retirement. IRAs and 401Ks allow you to invest with pre-tax dollars, allowing the wonders of compound interest to grow your nest egg until it can help support you when you are no longer working.

Careful planning on the part of the individual has never been more important. Few people have the luxury of relying on company-provided pensions any longer, and Social Security alone won’t provide for the life most are hoping for in their golden years.

It’s critical to be aware of all the rules surrounding these retirement accounts in order to avoid making any mistakes and incurring penalties. Let’s take a look at a big one.

Don’t forget to draw on your account

The tax man knows that you haven’t paid taxes on the funds in these retirement accounts — that’s the whole point — but the government wants its cut at some point. That’s why it mandates that once you hit a certain age, you must begin withdrawing partially from your retirement accounts each year and paying taxes on the withdrawal. The minimum amount the IRS requires is known as the required minimum distribution (RMD).

Once you’re 73 or older, by the end of each year, you must have withdrawn your RMD. There’s a one-time extension the year you hit 73, giving you until Apr. 1 of the following year to take your RMD. This includes both employer-sponsored retirement accounts like 401(k)s 403(b)s as well as individual accounts like traditional IRAs and SEPs. If you’re still working, however, the RMD is delayed for any employer-sponsored retirement account from your current employer.

Here’s how you calculate the RMD

In general, the RMD for the current year is calculated by dividing your retirement account balance at the end of the prior year by your current life expectancy. Luckily, you don’t have to guess how much longer you have; the IRS does the handiwork of determining that for you.

Source: IRS

Here’s your RMD if you have $500,000 in your retirement account

Hopefully, it’s clear at this point that the answer to this depends on how old you are, so to keep things simple, let’s say you are 75. Before 2025 begins, you need to withdraw $500,000 divided by 24.6 or $20,325 from your account. If you are 85? Your RMD would be $31,250.

Here’s what happens if you fail to withdraw your RMD

If you don’t follow the RMD rules, the IRS will levy an automatic tax penalty of 25% of the amount you failed to withdraw. For many retirees, this is much higher than their marginal tax rate, so it’s best to avoid this altogether and withdraw your RMD before the year is out.

However, if you do forget but correct your mistake within two years, the IRS can decrease your penalty to just 10%.

Here’s what you can do with the money

Once the money is withdrawn, remember that you don’t have to spend it if you don’t need to. A high-yield savings account can be a great place to park the money if you may need access to it in the near future. Otherwise, conservatively reinvesting in stocks and bonds can be a smart move.

If you are in a position where your RMD is going to lead to a high tax burden and you can afford to give that money away, know that a qualified charitable distribution (QCD) is an option. Money can be transferred directly from your IRA or 401(k) to a charity of your choice. This QCD will satisfy the IRS’s RMD requirement and won’t raise your tax burden. There is a limit, however. In 2024, the QCD is capped at $105,000.

Once you reach the age required for RMDs, ensure that you withdraw the prescribed amount to satisfy IRS requirements. By understanding the rules involved before you get there, you can better avoid the pitfalls.

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