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You may not have heard the term “risk-based pricing” before, but you’ve likely seen it in action if you’ve ever gotten a loan or a credit card.

Risk-based pricing is when lenders decide which interest rate and other loan terms to offer a borrower based on that person’s creditworthiness. If the lender believes you may default or struggle to make payments on a loan, for example, you’ll likely be offered a higher rate — or you could be turned down altogether. On the other hand, if your chances of defaulting are low, you can expect to be offered a more competitive rate and better loan terms.

Read on for a look at how risk-based pricing could affect your loan terms and ways to improve your risk profile in order to secure the best rate possible.

Risk-Based Pricing Explained

If you’ve ever applied for a loan or credit card, you’ve probably noticed that everyone isn’t offered the same interest rate and terms. That’s because financial institutions typically use risk-based pricing to determine how much they’ll charge borrowers for the money they lend.

What Is Risk-Based Pricing?

The idea behind risk-based pricing is fairly straightforward: Different borrowers get different rates depending on the level of risk the lender believes it’s taking. This allows financial institutions to provide options to a wide range of consumers while also making sure they’re being compensated for taking a chance on those who may be less creditworthy.

How Risk-Based Pricing Works

A key part of the loan underwriting process is assessing a borrower’s risk profile. Lenders can’t legally consider factors such as age, race, or gender when they’re deciding whether to approve a loan application. But they can — and do — use risk-based pricing models to help determine if a borrower should get a loan and if that loan should cost more or less based on financial criteria.

Lenders want to be as sure as possible they’ll be repaid on time and in full. And though there’s no guarantee a borrower with a good financial reputation won’t default on a loan, lenders typically see it as a solid indicator of a favorable outcome.

This means an applicant with an excellent credit score and other positive financial factors can expect to be offered a lower interest rate than a person with average, fair, or poor credit. This is true whether they’re seeking a car loan, personal loan, or a mortgage.

Creditworthiness can also affect loan fees and repayment terms, and the rewards and perks available with certain credit cards.

Factors that Can Influence Risk-Based Pricing

The criteria used to determine loan eligibility and pricing can vary by lender, but here are some of the factors that are typically included in a risk assessment:

Credit Score

A credit score is calculated using information such as payment history, existing debt obligations, and credit utilization from a current credit report. Lenders typically use this three-digit score as an indicator of a person’s overall financial well-being. The higher your credit score, the more likely you are to be approved for a loan and receive better financing terms.

A score of 670 to 739 is generally considered “good” on the credit rating scale, while scores of 740 to 799 are in the “very good” range, and 800 and above is “excellent.” Individual lenders may set their bar higher or lower when judging credit applicants.

Credit History

To get a more complete look at how you’ve handled credit in the past, lenders may also check one or more of your credit reports for signs of trouble. Potential red flags include past delinquencies, a mortgage foreclosure, bankruptcy, or debts that went to collection.

Income

Your income and employment history also can be a factor in determining risk. Lenders will want to see documentation that shows you earn enough to repay the loan and that you have stable employment.

Debt-to-Income Ratio

Along with your income, lenders will take a look at your debt-to-income (DTI) ratio to ensure you can manage all your debt payments. (You can calculate your DTI by dividing your monthly debt payments by your monthly gross income.) An acceptable DTI may vary by lender and the type of loan you are applying for. But in general, a DTI ratio below 43% is considered good, while many lenders prefer 36% or below.

Loan Type

Lenders tend to look at different types of debt as carrying varying levels of risk. For example, loans that are secured with some kind of collateral or down payment, such as mortgages, car loans, and home equity loans, usually come with lower interest rates than unsecured loans and credit cards.

Impact on Consumers

It may seem as though risk-based financing is all about protecting lenders — helping them minimize their losses by allowing them to tailor their rates to fit an individual borrower’s risk profile. But because it expands the range of lending options to include those with fair or even poor credit, risk-based lending can also benefit those who otherwise might not qualify for financing.

It also can serve as an incentive to consumers to improve their credit reputation in order to improve their loan terms in the future by refinancing, negotiating for a new and better rate on a current loan, or waiting to apply for financing until their credit is in better shape.

Regulations Governing Risk-Based Pricing

How can you know if you’ve been personally impacted by risk-based pricing? The Federal Trade Commission (FTC), Consumer Financial Protection Bureau (CFPB), and federal banking agencies have all published rules stating that if a lender denies a loan application or offers “materially less-favorable terms” based on a consumer credit report, it must provide the applicant with a notice that explains this decision. If you don’t agree with the terms you’ve been offered — for example, if you’re given a higher-than-expected annual percentage rate (APR) — you aren’t obligated to accept the loan.

Recommended: APR vs Interest Rate: What’s the Difference?

Pros and Cons of Risk-Based Pricing

As with most things related to finances, there are benefits and drawbacks associated with risk-based pricing.

Strategies to Improve Your Risk Profile

If you’re trying to build or rebuild your credit, risk-based lending may seem unfair or even punitive. But if you keep working on your financial health, you can eventually replace the missing or negative information on your credit reports with positive numbers.

Here are some steps that can help you boost your credit profile and show lenders you’re worthy of better loan terms:

Pay Off Debt

Paying down high-interest credit card balances and lingering loan debt can help you raise your credit score and lower your DTI — two key factors lenders look at when determining a borrower’s risk. If you’re repaying several debts to different lenders, you may want to look into how debt consolidation works and whether it makes sense for you.

Increase Your Income

If a low-paying job is getting in the way of getting a loan, you might consider taking on a side gig, asking for a raise, or looking for an employer that pays more for what you do.

Monitor Your Credit Score and Credit Reports

Regularly reviewing your credit reports and promptly disputing dated info or errors can help you ensure your credit profile reflects your current financial standing. You can check your credit score for free through your bank, credit card company, Experian, or a money tracker app. And you’re entitled to a free credit report weekly from each of the three credit bureaus via AnnualCreditReport.com.

Choose Appropriate Loan Products

Think about how you plan to use the money you want to borrow and which lending product might be the best choice for that goal. If you plan to make a major purchase, for example, a personal loan might be a better option than a credit card, because interest rates are typically lower.

Recommended: What Is Risk Tolerance?

Do Some Comparison Shopping

You also may be able to save money by taking the time to shop around for the best rates and terms available for the type of loan or credit card you want. Some lenders and loan types may have less-stringent standards for borrowers than others. And while you’re looking, you can read online reviews of the lenders you’re considering.

The Takeaway

For low-risk borrowers, risk-based pricing could mean a lower interest rate and other favorable terms. For a higher-risk borrower, it can result in a more expensive loan — or the loan application being rejected. This is why it’s a good idea to know where your credit stands before you apply for any type of financing. That way, you can be an informed shopper as you look for the best rates and terms based on your current creditworthiness. Or you can work to improve your financial health so lenders regard you as less of a risk.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.

FAQ

How does risk-based pricing differ from flat-rate pricing?

With risk-based pricing, the cost of a loan can be adjusted to fit the creditworthiness of the borrower. With flat-rate pricing, everybody who is approved is charged the same rate, whether they have good, bad, or fair credit.

Can I negotiate better terms if I’m offered high rates due to risk-based pricing?

Whether or not you can negotiate better terms may depend on the type of loan you applied for and the lender. If, for example, you’re a long-standing customer, your lender may be willing to work with you even if you present as a high-risk borrower.

How often do lenders reassess risk for existing loans?

Because a borrower’s risk profile can change over time, lenders may periodically review a customer’s credit score, payment history, and other financial factors. How often that happens varies by lender.

Are all types of loans subject to risk-based pricing?

The rates and terms borrowers are charged for most loan types are based on risk-based pricing.

Photo credit: iStock/MicroStockHub

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SOPL-Q424-002

Adding a shed to your home can mean the difference between rummaging around in a cluttered garage for a tool and having sundry garden tools, outdoor equipment, and off-season lawn furniture all in a designated space. Having a spot to store such items can save time and reduce mental fatigue.

One thing: Sheds can be expensive. According to HomeAdvisor, sheds can cost anywhere from $200 to $30,000 to build, with an average cost of $3,500.

Don’t have the cash on hand to front the costs? Enter shed financing. Here, we’ll walk you through different options for shed financing and alternatives to consider.

Understanding the Cost of Shed Installation

As mentioned, the average cost to build a shed is $3,500. When installing one of these structures, you’ll need to consider factors like size, building materials, labor costs, and details such as windows, doors, and electrical wiring. As you might expect, designing and building a custom shed is more expensive than constructing one from a premade kit.

Figuring out the cost per square foot can give you a general idea of the total price tag. But to determine the true cost of a shed, you’ll want to do your homework to figure out the cost of materials, labor, and permits.

Personal Loans for Shed Financing

A popular route for shed financing is to take out a personal loan. The beauty of personal loans is their flexibility — the funds can be used for essentially anything. Plus, personal loan amounts often start as low as $500, so they can be a good fit for smaller DIY projects like building a shed.

Payment terms on a personal loan are typically between two and seven years, which can provide some breathing room in your budget. And personal loans tend to have lower interest rates than credit cards. As of August 2024, the national average for interest rates on a 24-month personal loan is 12.33%, while the national average for interest rates on a credit card is 21.76%. (Use a personal loan calculator to figure out what the monthly payments might be, depending on the loan term and interest rate.)

If you know the total cost of the shed, you can use the proceeds from a home improvement loan to cover the different expenses. However, be aware that some lenders charge an origination fee, which can be anywhere from 1% to 5% of the loan amount — and sometimes as high as 10%. This one-time upfront fee is taken from your loan proceeds.

A couple of drawbacks of a personal loan include being responsible for monthly payments, which kick in after you receive the loan proceeds. Plus, lenders will need to do a hard pull of your credit, which can cause your credit score to temporarily dip by a few points.

Recommended: Where to Get a Personal Loan

Contractor Financing and Payment Plans

Besides personal loans, another way to pay for a shed is to get financing directly from the contractor. Some contractors have teamed up with third-party lenders to offer customers a loan option to cover the costs of a home improvement project. Like a personal loan, contractor financing is an installment loan, which means you’re responsible for making monthly payments until the balance is paid off.

While it can be an easy way to get a shed loan, interest rates from contractor financing can be more expensive than other options. Plus, you’re stuck with the contractor if things go south with the project.

Comparing Shed Financing Alternatives

If you’re curious about options besides a personal loan or contractor financing, here are some other ways to finance a shed.

Savings

If you’re not in a rush, you can pause on installing a shed. Instead, figure out how much you’ll need and put money into a savings account. To help you make steady progress in your goals, automate your savings, and figure out a target date and amount.

Family Loans

Family loans are something to consider should you have trusted friends or family who might have the means to give you a loan. As you’ll potentially be mixing personal relations with financial matters, take the time at the outset to discuss any concerns. And just like with any other type of loan, go over the terms and come up with a written plan to pay back the money.

Credit Cards

Tapping into an existing card can be an easy way to finance a shed, but it can also be expensive. Credit card interest rates are usually higher than other types of financing, and if you fall behind on payments, you could get hit with late fees.

Home Equity Loan or HELOC

Have you built up some equity in your home? You may want to consider borrowing against it by taking out a home equity loan or a home equity line of credit (HELOC). Both options are often easier to qualify for than unsecured forms of credit, such as a personal loan or a new credit card. However, if you’re unable to keep up with payments, you risk losing your home.

Tips for Securing an Affordable Shed Loan

Remember, the less you pay in interest and fees, the less expensive the total cost of your shed loan. Here are some steps you can take to help you position yourself for better rates and terms.

Build Your Credit

Having a good or excellent credit score can mean lower interest rates and more flexible terms. To build good credit, stay on top of your monthly payments, keep credit usage low and unused credit cards open, and avoid overspending.

Explore Shed Options

Before applying for a personal loan for a shed, poke around and see the options in terms of size, materials, and details like the door, windows, and shelving. Request estimates to get an idea of the type of shed you’d like to build.

Understand How Much You Need to Borrow

Knowing the type of shed you’d like to build helps you narrow the costs involved. Once you have a ballpark figure, borrow only what’s necessary.

Get Preapproved

If possible, get preapproved for loans from different lenders. That way, you can gauge the loan amount and terms you’ll likely qualify for. Lenders typically allow you to get preapproved online, and the process generally requires a soft credit pull, which won’t impact your credit score.

Recommended: Garage Financing: What Are Your Options?

The Takeaway

While building a shed can be expensive, landing on an affordable way to finance the project is doable. Start by doing your homework on different shed options, and use your findings to determine how much you’ll likely need to borrow. From there, start exploring the financing choices available to you and decide what makes the most sense for your finances.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.

FAQ

Are there any government programs for shed financing?

Government programs are available, and you might be able to use the proceeds from the loan or grant to finance a shed. However, you’ll need to meet eligibility criteria, which can depend on your income, age, location, type of home improvement project, and whether you belong to certain groups.

How do shed loans compare to other home improvement loans?

Shed loans are the same as other home improvement loans. One main difference is the loan amount. How much you need to borrow depends on several factors, including the shed type, the size, and whether you’re building from scratch or constructing one from a prefabricated kit.

What is the typical repayment period for a shed loan?

Shed loans, which are a type of personal loan, usually have repayment terms of between two and seven years. You’ll want to get a loan term that’s a good fit for your budget and a monthly payment you can afford.

Photo credit: iStock/irina88w

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SOPL-Q424-004

When you turn 73, the IRS requires you to start withdrawing money from your 401(k) each year. These withdrawals are called required minimum distributions (or RMDs), and those who don’t take them face potential financial penalties.

The 401(k) RMD rules also apply to other tax-deferred accounts, including traditional IRAs, SIMPLE and SEP IRAs. Roth accounts don’t have RMDs for the account holder.

What’s important to know, as it relates to RMDs from 401(k)s, is that there can be tax consequences if you don’t take them when they’re required — and there are also tax implications from the withdrawals themselves.

What Is an RMD?

While many 401(k) participants know about the early withdrawal penalties for 401(k) accounts, fewer people know about the requirement to make minimum withdrawals once you reach a certain age. Again, these are called required minimum distributions (or RMDs), and they apply to most tax-deferred accounts.

The “required distribution” amount is based on specific IRS calculations (more on that below). If you don’t take the required distribution amount (aka withdrawal) each year you could face another requirement: to pay a penalty of 50% of the withdrawal you didn’t take. However, if you withdraw more than the required minimum each year, no penalty applies.

All RMDs from tax-deferred accounts, like 401(k) plans, are taxed as ordinary income. This is one reason why understanding the amount — and the timing — of RMDs can make a big difference to your retirement income.

What Age Do You Have to Start RMDs?

Prior to 2019, the age at which 401(k) participants had to start taking RMDs was 70½. Under the SECURE Act that was raised to age 72. But the rules have changed again, and the required age to start RMDs from a 401(k) is now 73 — for those who turn 72 after December 31, 2022.

However for those who turned 72 in the year 2022, at that point age 72 was still technically the starting point for RMDs.

But if you turn 72 in 2023, you must wait until you turn 73 (in 2024) to take your first RMD.

In 2033, the age to start taking RMDs will be increased again, to age 75.

How Your First Required Distribution Is Different

There is a slight variation in the rule for your first RMD: You actually have until April 1 of the year after you turn 72 to take that first withdrawal. For example, say you turned 72 in 2022. you would have until April 1, 2023 to take your first RMD.

But you would also have to take the normal RMD for 2023 by December 31 of the same year, too — thus, potentially taking two withdrawals in one year.

Since you must pay ordinary income tax on the money you withdraw from your 401(k), just like other tax-deferred accounts, you may want to plan for the impact of two taxable withdrawals within one calendar year if you go that route.

Why Do Required Minimum Distributions Exist?

Remember: All the money people set aside in defined contribution plans like traditional IRAs, SEP IRAa, SIMPLE IRAs, 401(k) plans, 403(b) plans, 457(b) plans, profit-sharing plans, and so on, is deposited pre-tax. That’s why these accounts are typically called tax-deferred: the tax you owe is deferred until you retire.

So, requiring people to take a minimum withdrawal amount each year is a way to ensure that people eventually pay tax on the money they saved.

How Are RMDs Calculated?

It can get a bit tricky, but 401(k) RMDs are calculated by dividing the account balance in your 401(k) by what is called a “life expectancy factor,” which is basically a type of actuarial table created by the IRS. You can find these tables in Publication 590-B from the IRS.

If you’re married, there are two different tables to be aware of. If you are the original account owner, and if your spouse is up to 10 years younger than you, or is not your sole beneficiary, you’d consult the IRS Uniform Lifetime Table.

If your spouse is the primary beneficiary, and is more than 10 years younger, you’d consult the IRS Joint and Last Survivor table. Here, the RMD might be lower.

How does the life expectancy factor work?

As a simple example, let’s say a 75-year-old has a life expectancy factor of 24.6, according to the IRS. If that person has a portfolio valued at $500,000, they’d have to take an RMD of $20,325 ($500,000/24.6) from their account that year.

RMDs can be withdrawn in one sum or numerous smaller payments over the course of a year, as long as they add up to the total amount of your RMD requirement for that calendar year.

RMD Rules for 401(k) Plans

So just to recap, here are the basic RMD rules for 401(k) plans. Because these rules are complicated and exceptions may apply, it may be wise to consult with a professional.

Exceptions to Required Distributions

There aren’t many exceptions to 401(k) RMDs. In fact, there’s really only one.

If you’re working for the company sponsoring your 401(k) when you turn 73 years old (as of 2023), and you don’t own more than 5% of the firm, you may be able to skirt RMDs. That is, so long as you keep working for the company, and as long as your plan allows you to do so — not all will.

This only applies to 401(k)s. So if you’re weighing your options as it relates to a 401(a) vs 401(k), for instance, you’ll find they’re limited.

At What Age Do RMDs Start?

As mentioned, you must take your first RMD the same year you turn age 73, with the new rules being applied for 2023 under the SECURE ACT 2.0. Again: for your first RMD only, you are allowed to delay the withdrawal until April 1 of the year after you turn 73.

This has pros and cons, however, because the second RMD would be due on December 31 of that year as well. For tax purposes, you might want to take your first RMD the same year you turn 73, to avoid the potentially higher tax bill from taking two withdrawals in the same calendar year.

What Are RMD Deadlines?

Aside from the April 1 deadline available only for your first RMD, the regular deadline for your annual RMD is December 31 of each year. That means that by that date, you must withdraw the required amount, either in a lump sum or in smaller increments over the course of the year.

Calculating the Correct Amount of Your RMD

Also as discussed, the amount of your RMD is determined by tables created by the IRS based on your life expectancy, the age of your spouse, marital status, and your spouse’s age.

You’re not limited to the amount of your RMD, by the way. You can withdraw more than the RMD amount at any point. These rules are simply to insure minimum withdrawals are met. Also keep in mind that if you withdraw more than the RMD one year, it does not change the RMD requirement for the next year.

Penalties

The basic penalty, if you miss or forget to take your required minimum distribution from your 401(k), is 25% of the amount you were supposed to withdraw — or 10% if the amount is corrected within two years. (The penalty used to be 50%, but in 2023, under SECURE 2.0, it was reduced.)

For example, let’s say you were supposed to withdraw a total of $10,500 in a certain year, but you didn’t; in that case you could potentially get hit with a 25% penalty, or $2,625. But let’s say you’ve taken withdrawals all year, but you miscalculated and only withdrew $7,300 total.

Then you would owe a 25% penalty on the difference between the amount you withdrew and the actual RMD amount: $10,500 – $7,300 = $3,200 x .25 = $800. However, if you corrected the mistake within two years, you would only owe a 10% penalty, which is $325.

How Did COVID Change RMD Rules?

The pandemic ushered in some RMD rule changes for a time, and it may be easy to get mixed up given those changes. But you should know that things are more or less back to “normal” now (as of 2021) as it relates to RMD rules, so you’ll need to plan accordingly.

As for that rule change: There was a suspension of all RMDs in 2020 owing to COVID. Here’s what happened, and what it meant for RMDs at the time:

•   First, in 2019 the SECURE Act changed the required age for RMDs from 70½ to 72, to start in 2020.

•   But when the pandemic hit in early 2020, RMDs were suspended entirely for that year under the CARES Act. So, even if you turned 72 in the year 2020 — the then-new qualifying age for RMDs that year — RMDs were waived.

Again, as of early 2021, required minimum distributions were restored. So here’s how it works now, taking into account the 2020 suspension and the new age for RMDs.

•   If you were taking RMDs regularly before the 2020 suspension, you needed to resume taking your annual RMD by December 31, 2021.

•   If you were eligible for your first RMD in 2019 and you’d planned to take your first RMD by April 2020, but didn’t because of the waiver, you should have taken that RMD by December 31, 2021.

•   If you turned 72 in 2020, and were supposed to take an RMD for the first time, then you could have had until April 1, 2022 to take that first withdrawal. (But you could have taken that first withdrawal in 2021, to avoid the tax burden of taking two withdrawals in 2022.)

RMDs When You Have Multiple Accounts

If you have multiple accounts — e.g. a 401(k) and two IRAs — you would have to calculate the RMD for each of the accounts to arrive at the total amount you’re required to withdraw that year. But you would not have to take that amount out of each account. You can decide which account is more advantageous and take your entire RMD from that account, or divide it among your accounts by taking smaller withdrawals over the course of the year.

What Other Accounts Have RMDs?

While we’re focusing on 401(k) RMDs, there are numerous other types of accounts that require them as well. As of 2023, RMD rules apply to all employer-sponsored retirement accounts, according to the IRS — a list that includes IRAs (SEP IRAs, SIMPLE IRAs, and others), but not Roth IRAs while the owner is alive (more on that in a minute).

So, if you have an employer-sponsored retirement account, know that the IRA withdrawal rules are more or less the same as the rules for a 401(k) RMD.

Allocating Your RMDs

Individuals can also decide how they want their RMD allocated. For example, some people take a proportional approach to RMD distribution. This means a person with 30% of assets in short-term bonds might choose to have 30% of their RMD come from those investments.

Deciding how to allocate an RMD gives an investor some flexibility over their finances. For example, it might be possible to manage the potential tax you’d owe by mapping out your RMDs — or other considerations.

Do Roth 401(k)s Have RMDs?

No, Roth 401(k) plans no longer have required minimum distributions, similar to Roth IRAs. But if you bequeath a Roth IRA it’s another story. Since the rules surrounding inherited IRAs can be quite complicated, it’s wise to get advice from a professional.

Can You Delay Taking an RMD From Your 401(k)?

As noted above, there is some flexibility with your first RMD, in that you can delay your first RMD until April 1 of the following year. Just remember that your second RMD would be due by December 31 of that year as well, so you’d be taking two taxable withdrawals in the same year.

Also, if you are still employed by the sponsor of your 401(k) (or other employer plan) when you turn 73, you can delay taking RMDs until you leave that job or retire.

RMD Requirements for Inherited 401(k) Accounts

Don’t assume that RMDs are only for people in or near retirement. RMDs are usually required for those who inherit 401(k)s as well. The rules here can get quite complicated, depending on whether you are the surviving spouse inheriting a 401(k), or a non-spouse. In most cases, the surviving spouse is the legal beneficiary of a 401(k) unless a waiver was signed.

Inheriting a 401(k) From Your Spouse

If you’re the spouse inheriting a 401(k), you can rollover the funds into your own existing 401(k), or you can rollover the funds into what’s known as an “inherited IRA” — the IRA account is not inherited, but it holds the inherited funds from the 401(k). You can also continue contributing to the account.

Then you would take RMDs from these accounts when you turned 73, based on the IRS tables that apply to you.

Recommended: What Is a Rollover IRA vs. a Traditional IRA?

Inheriting a 401(k) From a Non-Spouse

If you inherit a 401(k) from someone who was not your spouse, you cannot rollover the funds into your own IRA.

You would have to take RMDs starting Dec. 31 of the year after the account holder died. And you would be required to withdraw all the money from the account within five or 10 years, depending on when the account holder passed away.

The five-year rule comes into play if the person died in 2019 or before; the 10-year rule applies if they died in 2020 or later.

Other Restrictions on Inherited 401(k) Accounts

Bear in mind that the company which sponsored the 401(k) may have restrictions on how inherited funds must be handled. In some cases, you may be able to keep 401(k) funds in the account, or you might be required to withdraw all funds within a certain time period.

In addition, state laws governing the inheritance of 401(k) assets can come into play.

As such, if you’ve inherited a 401(k), it’s probably best to consult a professional who can help you sort out your individual situation.

How to Avoid RMDs on 401(k)s

While a 401(k) grows tax-free during the course of an investor’s working years, the RMDs withdrawal is taxed at their current income tax rate. One way to offset that tax liability is for an investor to consider converting a 401(k) into a Roth IRA in the years preceding mandatory RMDs. Roth IRAs are not subject to RMD rules.

What Is a Roth Conversion?

A Roth conversion can be done at any point during an investor’s life, and can be done with all of the 401(k) funds or a portion of it.

Because a 401(k) invests pre-tax dollars and a Roth IRA invests after-tax dollars, you would need to pay taxes right away on any 401(k) funds you converted to a Roth. But the good news is, upon withdrawing the money after retirement, you don’t have to pay any additional taxes on those withdrawals. And any withdrawals are at your discretion because there are no required distributions.

Paying your tax bill now rather than in the future can make sense for investors who anticipate being in a higher tax bracket during their retirement years than they are currently.

The Backdoor Roth Option

Converting a 401(k) can also be a way for high earners to take advantage of a Roth. Traditional Roth accounts have an income cap. To contribute the maximum to a Roth IRA in 2024, your modified adjusted gross income (MAGI) must be less than $146,000 if you’re single, less than $230,000 if you’re married filing jointly, with phaseouts if your income is higher. To contribute the maximum to a Roth IRA in 2025, your modified adjusted gross income (MAGI) must be less than $150,000 if you’re single, less than $236,000 if you’re married filing jointly, with phaseouts if your income is higher. But those income rules don’t apply to Roth conversions (thus they’re sometimes called the “backdoor Roth” option).

Once the conversion occurs and a Roth IRA account is opened, an investor needs to follow Roth rules: In general, withdrawals can be taken after an account owner has had the account for five years and the owner is older than 59 ½, barring outside circumstances such as death, disability, or first home purchase.

What Should an Investor Do With Their RMDs?

How you use your RMD funds depends on your financial goals. Fortunately, there are no requirements around how you spend or invest these funds (with the possible exception that you cannot take an RMD and redeposit it in the same account).

•   Some people may use their RMDs for living expenses in their retirement years. If you plan to use your RMD for income, it’s also smart to consider the tax consequences of that choice in light of other income sources like Social Security.

•   Other people may use their 401(k) RMDs to fund a brokerage account and continue investing. While you can’t take an RMD and redeposit it, it’s possible to directly transfer your RMD into a taxable account. You will still owe taxes on the RMD, but you could stay invested in the securities in the previous portfolio.

Reinvesting RMDs might provide a growth vehicle for retirement income. For example, some investors may look to securities that provide a dividend, so they can create cash flow as well as maintain investments.

•   Investors also may use part of their RMD to donate to charity. If the funds are directly transferred from the IRA to the charity (instead of writing out a check yourself), the donation will be excluded from taxable income.

While there is no right way to manage RMDs, coming up with a plan can help insure that your money continues to work for you, long after it’s out of your original 401(k) account.

The Takeaway

Investors facing required minimum distributions from their 401(k) accounts may want to fully understand what the law requires, figure out a game plan, and act accordingly. While there are a lot of things to consider and rules to reference, ignoring 401(k) RMDs can result in sizable penalties.

Even if you’re not quite at the age to take RMDs, you may want to think ahead so that you have a plan for withdrawing your assets that makes sense for you and your loved ones. It can help to walk through the many different requirements and options you have as an account holder, or if you think you might inherit a 401(k).

As always, coming up with a financial plan depends on knowing one’s options and exploring next steps to find the best fit for your money. If you’re opening a retirement account such as an IRA or Roth IRA, you can do so at a brokerage, bank, mutual fund house, or other financial services company, like SoFi Invest®.

FAQ

Is my 401(k) subject to RMDs?

Yes, with very few exceptions, 401(k)s are subject to RMDs after its owner reaches age 73, as of 2023. What those RMDs are, exactly, varies depending on several factors.

How to calculate your RMD for your 401(k)?

It’s not an easy calculation, but RMDs are basically calculated by dividing the owner’s account balance by their life expectancy factor, which is determined by the IRS. That will give you the amount you must withdraw each year, or face a penalty.

Can you avoid an RMD on your 401(k)?

You can, if you’re willing to convert your traditional 401(k) account to a Roth IRA. Roth IRAs do not require RMDs, but you will owe taxes on the funds you convert.