Understanding Required Minimum Distributions

Tom von Alten
January 12, 2018

A required minimum distribution (RMD) is the amount that owners of traditional IRA (tIRA) and similar accounts (including 401(k)s) must begin distributing from their retirement accounts by April 1 following the year they reach age 70.5. The retirement saving incentive tax deferral is not "forever."

The RMD is calculated as a fraction of the value of the account at the end of the preceding year. (If you have more than one tIRA, the RMD is based on their aggregate value.)

In order to encourage you to take your RMD (and finally pay income tax on the funds), the law provides for a 50% excise tax on the amount not distributed as required. That is, if you were supposed to distribute $1,000 and did not, you'll have to pay $500 in excise tax (unless you can show your failure was "due to reasonable error").

You really want to take that RMD.

The appendices of Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs) explain in detail how to calculate the RMD.

The fraction is based on actuarial life expectancy for your age (and your spouse's age, if applicable). The idea is a more or less straight-line drawdown for your remaining years. If your life expectancy is 27.4 years, your RMD is 1 / 27.4 = 3.65% of your previous account balance. The next year, your life expectancy is a little less, and the RMD fraction is a little more (of what would be a smaller balance, if there is no growth in your investments).

The line flattens out as you get older, because your life expectancy increases a bit if you manage to stay alive.

If we use the "uniform lifetime" table III (where they use the term "distribution period" rather than "life expectancy"), and plot the increasing fraction with age, we see an increasing exponential curve that ends at 52.63% at age 115. (The law gives you a break after that; you only have to take out 52.63% every year afterwards.)

Subtracting the RMD fraction from the account each year, it's a fairly straight slide toward zero (at age 97) to begin with, but levels out the longer you live, asymptomptic to $0 in your 110s.

Figure 1: RMD time series - from Pub. 590 Table III

Figure 1

In the real world, you can invest your IRA assets and obtain some return, even while inflation erodes the purchasing power of your money. Many retirees find that their assets grow, and thus the dollar amount of the RMD ($RMD) increases year to year.

If we estimate a uniform 4% gain year-to-year, we'll see that the $RMD increases—significantly—year over year. For a $1,000 account, the initial $36.50 RMD will increase to as much as $65.

But inflation erodes the dollar's purchasing power. If we estimate 2% inflation, we see the RMD amount in "fixed," age-70 dollars increases to a more modest maximum, and tails off sooner. Figure 2 shows the no-growth/no-inflation RMD amount, and the effect of including an estimated annual growth in assets, and that estimate combined with inflation.

Figure 2: RMD $ amount for initial $1,000 acct. value

Figure 2

Different estimates for investment gain, and for inflation, and of course the actual change you see in your investments and inflation year to year will cause the RMD amount to vary from this simplified projection. Planning for your retirement income is a larger topic that includes Social Security, non-IRA investments, etc.