The Costly Retirement Mistake Many Americans Keep Making and Why It Happens Again and Again

It is unfair that Americans spend decades saving for retirement through 401(k)s and IRAs, benefiting from tax advantages along the way, only to lose money to the Internal Revenue Service (IRS) penalties for a recurring year-end mistake.

Many are unaware of this crucial financial rule. According to Vanguard, retirees lose up to $1.7 billion (£1.2 billion) annually in tax penalties for failing to take the required minimum distributions (RMDs) once they reach the age of 73.

Losing $1.7B to Tax Penalties

The IRS penalties for not taking RMDs can reach up to 25% of the amount due each year. Vanguard estimates that 6.7% of its clients missed their annual withdrawals in 2024. The average RMD was $11,600 (£8,612), which could have incurred a maximum penalty of 25%, or $2,900 (£2,153). The firm forecasts that around 8.7 million IRA owners are at RMD age, with approximately 6.7%, or 580,000 individuals, missing their RMDs. While around 24% of these investors did make withdrawals, their amounts were often too low to satisfy the RMD requirement.

Penalties Applicable to Heirs

The first RMD must be taken by 1st April of the year after reaching age 73, with subsequent withdrawals due by 31st December each year. RMDs are calculated based on account balances, age, and an IRS life expectancy factor. This deadline also applies to heirs, such as non-spouse beneficiaries. For example, adult children who have inherited IRAs need to start annual withdrawals in 2025 if the original IRA owner had reached RMD age before passing away. Since 2020, some heirs are also required to fully cash out inherited IRAs within a decade.

Missing RMDs Are Sticky

Vanguard's analysis shows that investors who take RMDs generally do so again the following year. However, 55% of those who miss their RMDs in one year also fail to take a withdrawal the next. Most Americans who miss their RMDs have balances under $5,000 (£3,712).

'Most investors seem to make RMDs a routine, but rather than "set and forget", many simply "forget and forget",' said Vanguard's Andy Reed.

Avoiding Hefty Penalties

According to the IRS, penalties for missed RMDs can be reduced to 10% if the withdrawal is 'timely corrected' within two years and Form 5329 is submitted. The IRS also waives tax penalties entirely if the shortfall was due to 'reasonable error' and the individual has taken 'reasonable steps' to rectify the mistake.

Fidelity's Sham Ganglani advises that if you miss the deadline, you should take your RMD as soon as possible, as the IRS is generally willing to work with individuals who act promptly and responsibly.

'With investors changing jobs nine times or more during their working lives, it's tough to keep track of all retirement accounts,' said Goodman. 'Combining IRAs and setting RMDs on autopilot removes the risk of forgetting.'

Vanguard recommends that investors utilise auto-RMD services to ensure timely withdrawals. Consolidating smaller accounts can also make it easier to remember to take RMDs from multiple 'small pots'.

Disclaimer: Our digital media content is for informational purposes only and does not constitute investment advice. Please conduct your own analysis or seek professional advice before investing. Remember, investments are subject to market risks, and past performance does not guarantee future returns.