Retirees Be Warned: This Distribution Mistake Could Trigger A Tax Surprise

Plenty of complex tax rules come into effect throughout a typical consumer's life. Those bringing children into their family can utilize child tax credits to offset their earnings, often boosting their tax return by a significant margin. Others may face an emergency that requires cashing out a 401(k) account early. Retirees with savings in traditional IRAs and 401(k)s also have to consider the tax implications of their financial decisions, since these accounts come with rules that shouldn't be ignored. Upon hitting 73, you must start taking Required Minimum Distributions (RMDs) from these accounts, with annual requirements calculated based upon your life expectancy and the account value. Failing to completely meet this requirement will result in a 25% excise tax being charged on the missed withdrawal — a nasty surprise that will drive your tax bill sharply north.

Several guidelines apply here, and this additional tax hit can be reduced to 10% if you correct it within two years of the missed distribution. The Internal Revenue Service (IRS) also notes that the penalty rate can be waived if the distribution is missed because of a "reasonable error," and you are taking "reasonable steps" to correct the situation. If you do fall victim to this mistake, however, it's important to remember to include Form 5329, along with a letter explaining your situation, in your tax filing the following year. This will get the ball rolling on minimizing or waiving the penalties incurred. 

Calculating your RMDs simply involves dividing your account value by your life expectancy factor, which you can find on the IRS Uniform Lifetime Table. You'll need to perform this calculation separately for all your IRA accounts, but you can withdraw the total amount from just one. With 401(k)s, you must calculate and take the RMDs separately from each of the plans. 

But calculating the amount you need to take from these accounts is only the first step. Because RMDs come from accounts that are taxed as regular income, you typically won't want to withdraw much more than the minimum figure from them each year. Withdrawing more than the RMD means paying more in taxes than is necessary, after all; unfortunately, underestimating the figure costs you in penalties. 

Minimizing your tax liability in retirement allows you to keep more of your money in growth vehicles instead of losing it to the IRS. The best approach is to mix distributions from taxable and Roth accounts: Take the RMDs first, then supplement with Roth withdrawals. Limiting the amount counting toward your regular income allows you to keep your tax bill to a bare minimum, extending the life of your retirement funding in the process.