Many people are not thrilled with Required Minimum Distributions (RMDs). They have contributed to their retirement plans over the years and are not happy that now they have to take a distribution and essentially share the money with the IRS. We understand their frustration.
In addition, defined benefit plan RMDs are substantially higher than defined contribution plan RMDs. This just exacerbates the problem.
In this article, we’ll discuss the basic formula for defined benefit plan RMD calculations and compare it to the defined contribution plan formula. Let’s get started.
Some Background
Required Minimum Distributions (RMDs) are the minimum amounts that individuals must withdraw annually from their tax-deferred retirement accounts once they reach a certain age, as mandated by the IRS. These accounts include traditional IRAs, 401(k)s, defined benefit plans, and other similar retirement plans.
RMDs are designed to ensure that individuals eventually pay taxes on the money that was contributed pre-tax and allowed to grow tax-deferred over time. The age at which RMDs begin has changed over time due to legislative updates; as of 2024, individuals generally must start taking RMDs at age 73, and this will increase to 75 in 2033.
The amount of each RMD is calculated annually based on the account balance at the end of the previous year and the account holder’s life expectancy or as determined by IRS tables. Failing to take the full RMD can result in a significant penalty, although recent legislation has reduced this penalty from 50% to 25%, and potentially 10% if corrected in a timely manner.
Defined Contribution Plan RMDs
First, we will look at how RMDs are calculated for defined contribution plans (including 401ks). To calculate RMDs for defined contribution plans, you must divide the account balance as of December 31st of the prior year by the applicable life expectancy factor from the IRS Uniform Lifetime Table. The IRS also has worksheets to assist in the process.
Here’s a breakdown of how the process works:
1. Determine the Applicable Age:
- Your age on your birthday in the year you need to take the RMD.
- For 2025, if you turned 73 in 2024, your first RMD is due by April 1, 2025, based on your account balance on December 31, 2023.
2. Locate the Life Expectancy Factor:
- Consult the IRS Uniform Lifetime Table (or Joint Life Expectancy Table if your spouse is more than 10 years younger and the sole beneficiary).
- Find the life expectancy factor corresponding to your age.
3. Calculate the RMD:
- Divide the account balance as of December 31 of the prior year by the life expectancy factor.
Example:
- Account Balance (December 31, 2024): $100,000
- Age (on your birthday in 2025): 73
- Life Expectancy Factor (from IRS Uniform Lifetime Table): 26.5
- RMD: $100,000 / 26.5 = $3,773.58
As you can see, the calculation for a defined contribution plan is rather straightforward. The important components are the account balance and the distribution period in years.
Defined Benefit Plan RMDs
But define benefit plan RMDs s are calculated substantially different. To understand this, you have to consider what a define benefit plan actually is.
Define benefit plan RMD’s must be calculated by an actuary. It is not something that can be completed by an individual with no experience. But there is a general approach that is taken.
A defined benefit plan is set up so once you reach retirement age (typically 62 or 65), you will receive a monthly payment (called an annuity) for your remaining life. Average lifespan based on mortality tables is roughly 80 years old. But this will go up or down a little bit from year to year. So, in theory, once you reached 80 years of age, your annuity payments would stop.
This same theory is applied when doing defined benefit plan RMDs. For example, let’s assume you were 73 years old and required to take your first RMD. If your average lifespan was 80 that means that you would have to take out your accrued benefit over your remaining lifespan, which would be approximately seven years.
As an example, if you had a $700,000 accrued benefit balance in your defined benefit plan and seven years remaining on your mortality table, then you would have to take out $100,000 a year in an RMD.
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But if you had that same $700,000 in a defined contribution plan, your uniform mortality computation would be 26.5 years. If you divide this by the $700,000 you get $26,415. This is approximately four times lower than what you get with a defined benefit plan.
An important point to note is that for a defined benefit plan, the actuary will use the participant’s “accrued benefit.” This is a different amount from the investment account balance. The accrued benefit is what the participant has “earned” under the plan, while the investment assets are used to fund this benefit. This difference can also result in variations from expected RMD amounts.
Why the Big Difference?
If you look at the calculation, you will notice that defined benefit plan RMDs are substantially greater than those for defined contribution plans and IRAs. The main difference is the distribution period that is measured in years.
In the example above, we had to assume that the defined benefit plan was going to generate an annual annuity paid over seven years. The remaining lifespan would be the distribution period.
But with the defined contribution plan, you can use a distribution length of 26.5 years. Because this distribution length is so much longer, you can essentially spread out the RMDs over a much longer period of time. In contrast, the defined benefit plan RMDs are over a substantially shorter period of time, resulting in substantially higher RMD amounts.
To illustrate this, let’s take a look of a defined benefit plan RMD and defined contribution plan RMD side-by-side to illustrate this large difference:
| Defined Benefit RMD | Defined Contribution RMD | |
|---|---|---|
| Account balance as of year-end | $1,000,000 | $1,000,000 |
| Distribution period (in years) | 7 | 26.5 |
| RMD | $142,857 | $37,735 |
The above table illustrates the substantial difference in RMDs and highlights the impact of the different distribution periods in the calculation. Of course, the 7-year distribution period is just used for illustration purposes and will vary from year to year. But in any case, it will be substantially lower than the distribution years for the defined contribution plan.
Is a Cash Balance or Defined Benefit Plan Right For You?
How Does Vesting Impact an RMD?
Defined benefit plans, including cash balance plans, are subject to the same rules as IRAs and other qualified plans regarding required minimum distributions (RMDs). However, there is an important distinction: only the vested amounts in these plans are subject to RMDs, while non-vested balances are not. Since most plans operate on a 3-year cliff vesting schedule, this can provide a slightly longer timeframe before the RMDs apply.
If the goal is to delay RMDs, using the three-year vesting will certainly do that (even for a solo plan). But one important point to note: once the plan is fully vested, then RMDs are required. Because the person is now older, the RMDs are taken out over a shorter period of time. Now the RMD term is further compressed resulting in higher RMDs compared to if the plan was fully vested upfront.
Final Thoughts
Calculating Required Minimum Distributions (RMDs) for defined benefit plans differs significantly from the process used for defined contribution plans. In a defined contribution plan, the RMD is based on the account balance at the end of the previous calendar year and the participant’s life expectancy as provided by IRS Uniform Lifetime Tables. In contrast, defined benefit plans must use the accrued benefit and calculated out as an annuity over the individual’s remaining life.
Ensure you understand the key differences between these two plans and how your RMDs will be impacted. Your plan actuary can help you review your accrued benefit to minimize any RMD surprises.
