What it means
Retirement accounts such as traditional IRAs (individual retirement accounts) and many workplace plans let money grow without tax until it is withdrawn. Governments do not allow this to continue forever.
Once the owner reaches a certain age, annual withdrawals called required minimum distributions, or RMDs, must begin. The amount of an RMD is generally found by dividing the account balance at the end of the prior year by a life expectancy factor taken from an official table.
The factor gets smaller as the owner ages, so the percentage withdrawn rises each year. The owner can always take more than the minimum, but not less.
If the owner withdraws too little, the shortfall is subject to an excise tax, which is the excess accumulation penalty. The rate is set by law and has been changed by legislation in the past, so it should be checked each year.
In some cases the penalty can be reduced if the mistake is corrected promptly, and it can be waived if the owner shows a reasonable cause and takes steps to fix the problem. The penalty is charged on top of ordinary income tax, which is still owed on the amount that should have been withdrawn.
That is why missing a distribution can be expensive. The owner also loses the chance to have chosen when and how to take the income.
Good practice is to calculate the RMD early in the year, decide which accounts to draw from, and set up automatic withdrawals. Custodians (the firms that hold the accounts) often provide calculations, but the legal responsibility stays with the account owner.
A tax adviser can help with special cases such as inherited accounts or multiple plans.
In practice
Real-world examples.
Example
A retired teacher with two IRAs forgets that the second account also has a required distribution. She takes the full amount from the first account only. The shortfall on the second account is subject to the penalty, and she files a form to request a waiver after correcting the mistake.
Example
A business owner in his seventies holds a large balance in a traditional IRA and does not need the income. He sets up an automatic transfer each December for the exact required amount. This protects him from penalties without taking out more than necessary.
Example
A woman inherits her late father's IRA and does not realise that the inherited account has its own withdrawal rules. She leaves the money untouched for two years. Her adviser calculates the missed distributions and helps her file to reduce the penalty.
Formula
Calculation
Required minimum distribution = Prior year-end balance / Life expectancy factor
Shortfall = Required minimum distribution - Amount actually withdrawn
Penalty = Shortfall x Penalty rate
For illustration, assume the penalty rate is 25%. The real rate is set by law and can change, so always check the current figure.
Suppose a retiree has an IRA balance of $600,000 at the end of the prior year and the life expectancy factor is 25.0. The required minimum distribution is $600,000 / 25.0 = $24,000.
The retiree withdraws only $9,000, leaving a shortfall of $24,000 - $9,000 = $15,000. At the assumed 25% rate, the penalty is $15,000 x 25% = $3,750, and ordinary income tax is still due on the withdrawn amount.Case study
Seen in the real world.
Marlowe Ridge is a fictional retired engineer with a $900,000 traditional IRA. He changed financial adviser during the year, and the new adviser assumed that the previous firm had already processed his required withdrawal.
At the year end, no distribution had been made. The shortfall was $36,000, and the new adviser spotted the problem during the January review.
In this illustrative case, Marlowe took the missed amount straight away and wrote a letter explaining that the mistake was due to a handover error. The tax authority has discretion to waive the penalty when there is reasonable cause and the error is corrected, so he asked for a waiver and avoided a charge of several thousand dollars.
Watch out
Common mistakes.
- Believing that the custodian is legally responsible for taking the withdrawal, when the account owner carries the responsibility.
- Taking the full amount from one account when the rules require separate calculations for certain types of account.
- Assuming the penalty replaces income tax, when income tax is still owed on the required withdrawal.
Questions
People also ask.
Can the penalty be waived?
Yes, in some cases. The owner generally has to correct the shortfall, show a reasonable cause for the error and file the required form with the tax authority.
Does a Roth IRA have required withdrawals during the owner's lifetime?
Roth IRAs generally do not require the original owner to take distributions, though workplace Roth plans and inherited accounts can follow different rules. Check the latest rules before relying on this.
When do required withdrawals begin?
The starting age is set by legislation and has changed over time, so the owner should confirm the current age with the tax authority or an adviser.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%