Mandatory Distribution Meaning Calculation Example
Mandatory Distribution: Meaning, Calculation, Example
Amy Fontinelle has more than 15 years of experience covering personal finance, corporate finance, and investing.
What Is Mandatory Distribution?
Mandatory distribution refers to the minimum amount of money an individual must withdraw from certain tax-advantaged retirement accounts each year to avoid tax penalties. Mandatory distributions start at age 72 and are also known as required minimum distributions (RMDs).
Previously, RMDs started at age 70½ but changed with the passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act and SECURE 2.0 in 2022.
Key Takeaways
– Mandatory distributions occur when an individual reaches the required age for retirement account distributions.
– As of 2022, the age increased to 73 years old (for account holders born between 1951 and 1959) or 75 years old (for those born in 1960 or later) to take required minimum distributions from an IRA.
– The required minimum distributions for each account type are calculated differently.
– Excess withdrawals do not affect future required minimum distributions.
– Mandatory distributions are included in an individual’s taxable income except for those that have already been taxed or can be received tax-free.
How Mandatory Distributions Work
Mandatory distributions apply to various retirement accounts, including traditional IRAs, 401(k)s, 403(b)s, 457(b)s, SEPs, SARSEPs, SIMPLE IRAs, and Roth 401(k)s. They do not apply to Roth IRAs during the owner’s lifetime.
Once the age requirement is reached, individuals must take mandatory distributions by December 31 each year. Failure to do so incurs penalties, unless specific circumstances warrant a reduction to 10%. However, exceeding the mandatory distribution is allowed.
Mandatory distributions are taxed at the individual’s current marginal tax rate.
In the first year of mandatory distributions, some retirees take two years’ worth of distributions to maximize tax-advantaged investment returns.
Special Considerations
The rules for mandatory distributions differ when the retirement account is inherited or based on the beneficiary’s relationship to the original account holder.
For non-spouse adult children, trusts, or institutions, the entire inherited account must be drawn down within 10 years under the SECURE Act. Previously, non-spousal beneficiaries had the option to take RMDs throughout their lifetime.
Spouses, children under 18, or those with disabilities are not subject to the 10-year drawdown rule. They can choose to take mandatory distributions over their entire lifetime, beginning within one year of the original owner’s death.
If you expect to be in a lower tax bracket at retirement, funding a retirement account with pre-tax dollars is preferable.
Mandatory distribution amounts are based on the account balance and the account holder’s life expectancy, as determined by IRS tables. While IRA custodians usually calculate RMDs, it is the account holder’s responsibility to determine the correct minimum distribution amount.
Workers who don’t own more than 5% of their employer’s company can postpone mandatory distributions until the year after they retire.
How to Calculate a Mandatory Distribution
Mandatory distribution amounts are calculated separately for each account type. For an IRA, divide the account balance as of the previous December 31 by the life-expectancy factor found in IRS Publication 590-B, "Distributions from Individual Retirement Arrangements (IRAs)."
Publication 590-B provides three different tables based on different life situations: the Joint and Last Survivor Table, the Uniform Lifetime Table, and the Single Life Expectancy Table.
Example of Mandatory Distribution
Susan, who turned 73 this year, must take a mandatory distribution from her retirement account. With a previous-year balance of $200,000, she consults the Uniform Life Table in Publication 590-B. Her withdrawal factor is 25.6. Dividing $200,000 by 25.6, her required mandatory distribution for the year is $7,812.5.
What Types of Retirement Plans Require a Mandatory Distribution?
Most retirement plans require mandatory distributions, including traditional IRAs, 401(k)s, 403(b)s, 457(b)s, SEPs, SARSEPs, SIMPLE IRAs, and Roth 401(k)s. Roth IRAs are exempt from mandatory distributions during the owner’s lifetime.
What Is a Mandatory Distribution Calculator?
A mandatory distribution calculator, like the one provided by the Securities and Exchange Commission (SEC), allows individuals to determine their mandatory distribution based on age and account balance.
What Happens If You Fail to Take the Mandatory Distribution?
Failure to take the required mandatory distribution incurs a penalty of 50% on the amount that should have been withdrawn. For example, if the required minimum distribution for the year is $4,000 and not withdrawn, a $2,000 penalty is incurred.
How Are Mandatory Distributions Taxed?
Mandatory distributions are taxed at the individual’s applicable tax bracket at the time of withdrawal, unless they have already been taxed or do not qualify for taxation.
Does the Mandatory Distribution Affect Social Security?
Mandatory distributions count towards an individual’s combined income, which may result in their Social Security benefits being taxed. Depending on income, up to 85% of Social Security benefits can be subject to taxation.
The Bottom Line
Mandatory distributions, also known as required minimum distributions (RMDs), are the required amounts that individuals must withdraw annually from their retirement accounts once they turn 73 years old (for individuals born between 1951 and 1959) or 75 years old (for those born in 1960 or later). The specific amount to be withdrawn depends on factors such as age, and failure to make the distributions results in penalties. Mandatory distributions apply to most retirement accounts, with the exception of Roth IRAs.