There are tax benefits to contributing money to a retirement savings plan like a 401(k) or IRA. If you fund a traditional 401(k) or IRA, the money you put in is tax-free, and once invested, gains in your account are tax-deferred until you take withdrawals. With a Roth 401(k) or IRA, your money grows completely tax-free and withdrawals are tax-free, as well.
But the IRS doesn't want you benefiting from those tax breaks indefinitely, so once you reach age 72, you must remove a certain portion of your 401(k) or IRA balance each year or face costly penalties. The amount of money you're forced to remove is known as your required minimum distribution, or RMD, and it's calculated each year based on your account balance and life expectancy.
If you have a Roth IRA, you're not required to take RMDs, but all other tax-advantaged retirement plans impose them (including Roth 401(k)s, even though they're funded with after-tax dollars). And any time you fail to take an RMD, you lose 50% of the amount you don't withdraw. In the case of a $10,000 RMD, that's $5,000 thrown out, just like that.
This year, however, seniors get a bit of a break on the RMD front. Thanks to the CARES Act, which was implemented in response to the COVID-19 outbreak, retirees who are otherwise liable for RMDs do not have to take them in 2020. And that's beneficial for a couple of reasons.
The upside of delaying RMDs
Not having to take an RMD this year could save you money in more ways than one. First, unless you have a Roth 401(k), your RMDs are considered taxable income. As such, any RMD you take automatically increases your IRS liability, even if it's money you're only withdrawing because you have no choice. By not taking an RMD this year, you avoid taxes on the sum you'd otherwise have to remove.
Furthermore, right now, a lot of 401(k) and IRA balances are down due to the COVID-19-induced stock market crash, and it's hard to know when they'll recover. By not taking RMDs, seniors can avoid locking in the losses that would otherwise come with liquidating a portion of their retirement savings.
Of course, for some seniors, RMDs are a non-issue because they need to take out a certain amount of money from savings each year to pay their bills. But if you don't need to take a retirement plan withdrawal this year, you'd be wise to take advantage of the option to put off your RMD.
Incidentally, as part of the recently approved COVID-19 relief package, you may be entitled to a stimulus payment of up to $1,200, provided your income doesn't exceed a certain threshold. If you're right on the cusp of needing to take a retirement plan withdrawal to pay your bills, that payment may prevent you from having to do so. That's a good way to avoid losses in your account that take years from which to recover.
The $16,728 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.
The business news you need
With a weekly newsletter looking back at local history.