RMD Strategies to Reduce Taxes
How Planning Ahead Can Help to Minimize Your Tax Burden in Retirement
Are you saving for retirement with a traditional 401(k) or IRA? If so, you’re probably enjoying the fact that these investment vehicles are tax-deferred, meaning you haven’t had to pay any taxes on your contributions yet. That won’t happen until you take withdrawals from your accounts once you retire.
Most people assume this is advantageous because their income tax rate will be lower in retirement than it is while they’re working, and that’s certainly true for some people. So, for these folks, it’s savvy to save tax-deferred and then pay taxes on their savings later when the tax rate will be reduced. This is the ideal scenario.
So, what happens if your retirement tax scenario is… less than ideal? What if you tap into your accumulated wealth when you retire and, combined with Social Security and Required Minimum Distributions from your 401(k) or IRA, you end up in the same or higher tax bracket? Fortunately, there are a few strategies you can use to minimize the impact of your RMDs in order to reduce taxes, and we’ll discuss each of them below. First, though, let’s review RMD basics.
If you’ve been saving diligently for retirement through a variety of vehicles, you may find that you don’t need to withdraw any money from your 401(k) or IRA in retirement. Unfortunately, the IRS is going to require you to withdraw a certain amount once you reach a certain age. Per the Setting Every Community Up for Retirement Enhancement Act (SECURE Act), passed in 2020, you must begin taking annual withdrawals at age 72. (If you turned 70 ½ prior to December 31, 2019, your required age is still 70 ½.)
These annual withdrawals are called Required Minimum Distributions (RMDs), and the amounts will change over time. The IRS calculates your RMD amount by taking the sum of all your tax-deferred retirement accounts at the end of each tax year and dividing it by a number that is based on life expectancy and a few other factors. So, as you get older, the denominator will decrease. This means your RMD amounts will get larger and larger over the years. You can check out a chart of the denominators here.
The IRS holds you responsible for getting your RMD calculations correct each year, as well as for making the actual withdrawals on time. However, many 401(k) and IRA custodians notify account holders of their RMD amount each January or at least offer helpful calculators to facilitate correct math. If you miscalculate or fail to withdraw your RMD, you’ll face a steep penalty: the IRS charges 50 percent on RMDs that are not taken.
It's important to know that the first year you’re required to take an RMD is likely to be the toughest year tax-wise. This is because your initial distribution won’t be due until April 1 of the year you turn 72 (or 70 ½ if you’re subject to the old rule). Then, your second RMD is due on December 31 of that same year. This means two sizable withdrawals in one tax year, which could easily bump you up into a higher tax bracket. For this reason, it’s often a better strategy to take your initial distribution in the first calendar year for which it’s required.
Determining When to Begin Withdrawing Your Funds
There are multiple strategies available to you when it comes to drawing down your accounts. Let’s examine three of them:
Withdrawal Option 1 – Begin at Age 59 ½
Typically, your earliest opportunity to begin withdrawing funds from a tax-deferred account without incurring a penalty is age 59 ½. If you take this approach, you’ll want to be careful not to draw down enough to push you into the next tax bracket. This allows you to strategically reduce the overall size of your tax-deferred savings – and thus reduce the amount of your future RMDs, too. Another benefit of this strategy is that your withdrawals may help you avoid claiming Social Security, thereby allowing your government benefit to increase by 8 percent for every year you wait beyond your full retirement (up to age 70, after which the incremental benefits stop).
Option 2: Pursue a Roth Conversion
Another strategy that may prove beneficial is to convert your traditional IRA to a Roth IRA, which is exempt from RMDs. There are three main scenarios in which this move may make sense:
- When you believe you will fall into a higher tax bracket when you withdraw your money in the future
- If you want to manage or reduce distributions after your RMDs begin
- When you desire to leave your heirs an asset that will be income tax-free (Roth withdrawals are not subject to income tax once you’ve held the account for at least five years)
If your retirement income will be sizable and you don’t need your IRA to pay for living expenses, a Roth conversion may be the right approach. However, know that you’ll pay ordinary income tax on any amount distributed from your traditional IRA, and it will be advantageous to pay that tax liability from other assets if you’re under age 59 ½. This is because the IRS will charge a 10 percent penalty – on top of any ordinary tax – if you use IRA funds to pay the tax bill from your Roth conversion. If you’re over age 59 ½, however, using your IRA funds to pay your tax bill undercuts your strategy for the Roth conversion because it reduces the amount you have left to grow tax-free.
Option 3: Opt for a Qualified Charitable Distribution
Once you reach the age of requirement for RMDs (70 ½ or 72, depending on whether the SECURE Act applies to you), you also have the option of satisfying your RMD with a qualified charitable distribution (QCD). This is when your RMD withdrawal is transferred directly from your account to a charitable organization. A QCD satisfies your RMD, but it is not taxable. An individual can donate up to $100,000 per year in this manner, with a few caveats:
- The funds cannot pass through you to the charity – they must be transferred straight from your IRA to the 501(c)(3)’s account by your IRA custodian.
- The distribution won’t count as taxable income, but you also cannot claim it as a charitable deduction.
- A retired person turning 70 ½ in 2020 can still make a QCD, even though they would not be required to take one for this calendar year.
Putting Your Strategy in Motion to Reduce Taxes
Tax law is full of intricacies and can be quite complex to navigate without the assistance of a professional. If you have multiple tax-deferred accounts, plus Social Security or other potential sources of income, there are lots of moving pieces that require attention. In order to truly ensure you’re making tax-efficient decisions, it’s best to consult with a certified public accountant, a tax advisor, or a financial advisor.
At FC Wealth Solutions, we strive to help our clients find confidence in their financial future and the freedom to lead a fulfilled life. If you’re interested in strategies to reduce your tax burden in retirement, let’s start a conversation. Contact us today to schedule your complimentary meeting and learn more about how we can help you plan for the retirement you’ve been dreaming of.