A stunning 80% of American retirees are getting this RMD rule wrong ‘out of fear’ — and it could cost them thousands of dollars in lost income. Are you making this mistake?

The retirement consumption paradox

In reality, people often reduce their inflation-adjusted consumption when they retire, a phenomenon known as the “retirement consumption paradox.” This may occur from choice or from necessity.

For instance, 32% of retirees “are convinced they have not accumulated enough savings” and 68% are worried they will outlive their assets, according to the Schroders 2024 US Retirement Survey. Whether they’ve saved enough or not, they’re worried about inflation, healthcare costs, and market downturns.

It’s no wonder retirees are being prudent about how they withdraw their funds. But this is leading more than 80% of retirees to make the mistake of only taking their required minimum distributions (RMDs) from accounts that require them.

Doing this can cost retirees greatly because it may mean they’re restricting their income when they’re in a more active stage of their retirement and could potentially enjoy it the most. They then get the most income once they’ve slowed down and may have less need for it.

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What’s a required minimum distribution (RMD)?

An RMD is an annual withdrawal from a pre-tax retirement account, mandatory under Internal Revenue Service (IRS) rules. These include 401(k)s, 403(b)s, 457s, the government TSPs, and traditional IRA accounts.

You’re required to start taking RMDs by Dec. 31 of each year, beginning the year you turn 73. There’s a first-year exception that allows you to take your first RMD by April 1 of the year following the year you turn 73, but this will require you to take two RMDs that year. If you don’t take your RMD, you can face a tax penalty of up to 25% of the RMD that was due.

RMDs are calculated by dividing your account balance as of Dec. 31 of the previous year by the life expectancy derived from tables posted on the IRS website.

For instance, if you’re 77 years old, married (to someone who isn’t more than 10 years younger than you) and your balance as of Dec. 31 of last year was $1,000,000, then you divide $1,000,000 by 22.9 (your life expectancy), which gives you an RMD for this year of $43,668.

If you’re earning even a relatively conservative annual return of 4.6% on your portfolio, then you would once again have about $1,000,000 at the end of the next year, only this time your life expectancy is only 22.0, so your RMD is about $45,454.

If your return remains reasonable, you will replace part or all of your withdrawal each year, potentially leaving you with a large account balance and large withdrawals at a later age when you may not be able to enjoy them as much.

Of course, this could be a good thing if you want to leave something behind for your beneficiaries, but if not, you may be leaving thousands of dollars on the table — and perhaps enjoying your retirement more.

What can you do instead?

If you don’t need the money from your RMD, you can explore options such as a qualified charitable distributions (QCDs), which allow you to donate your RMD directly to charity. Usually RMDs are taxable as income, but for a charitable donation it’s not.

If you feel you don’t need the money now, but might need it later — such as for increased medical expenses — you may want to consider using your IRA or retirement plan funds to buy a qualified longevity annuity contract (QLAC). Payments from a QLAC can start as late as age 85 and are generally exempt from RMD requirements until then.

If you’re concerned about RMDs, you might consider rolling funds into a Roth account. You’ll pay taxes at the time of the rollover, but there are no RMDs for Roth accounts and, subject to certain conditions, withdrawals are tax free.

Your optimal withdrawal amount is likely not the same as your RMD — and it’s likely to change over time — so it may be a good idea to engage a financial adviser to help determine the amount that’s right for you.