When we reach the age of 70 ½ ,we are given the “privilege” of beginning Required Minimum Distributions (RMDs) from IRAs, 401(k)s and other retirement accounts. This requirement applies to all retirement accounts funded with pre-tax contributions and these annual distributions are now fully taxable at ordinary income tax rates. Since RMDs, and the associated taxes, can seriously erode your wealth, it is essential to find ways to minimize them where you can.
Step One: Understand RMD Taxation
Required minimum distributions are the government’s way of recovering the tax breaks on the initial contributions to your retirement account and the years of tax-deferred wealth.
Here is a scenario to bring this to life. Assuming someone is 70 ½, has a spouse less than 10 years younger and earns a 4 percent annual return, the first year RMD would be $36,496. With a 30 percent tax rate (federal and state) the net spendable distribution is $25,547. The taxes amount to $10,949. Looking at the total distributions, total taxes paid and the remaining account balance over time:
Over the years, I’ve seen people in their 80s being forced to take distributions exceeding $80,000 or more even though they don’t need the money.
This example illustrates the impact the RMDs can have on your wealth. After the 30 years, the taxes paid in this example would be about one-half the starting account value at age 70 ½. The total distributions taken would be about 1.6 times that original account value.
And it gets worse as you get older.
RMDs are a function of the ending balance in your account(s) at the end of the prior year and distribution period in the appropriate IRS table. Based upon the most commonly-used Uniform Lifetime Table, here is the impact of the distribution periods over time on a $1 million account balance:
As you can see, the shorter distribution period as you age makes the amount of the distribution larger, all things being equal. Over the years, I’ve seen people in their 80s being forced to take distributions exceeding $80,000 or more even though they don’t need the money. So it’s not uncommon to see retirees in higher tax brackets when they retire than when they were working.
Five Ways to Lessen the Destructive Impact of RMDs
Here are five ways to lessen the amount of your RMDs — or at least decrease the tax impact:
1. Qualified charitable distribution (QCD)
If you are at least 70 ½, the QCD rules let you divert up to $100,000 of your RMD to a qualified charitable organization. The amount given to the charity is not taxable, though there is no additional deduction for the charitable contribution. QDCs will lower your tax bite and allow you to fulfill your charitable intentions at the same time.
2. Qualified Longevity Annuity Contract (QLAC)
QLACs can be purchased within an IRA or 401(k) account and let the account holder defer a portion of an RMD from age 70 ½ to as late as 85. The annuity payments are deferred until then, conceivably as a backstop to avoid outliving your money. Potentially a good idea in theory, using a QLAC to defer RMDs may or may not be a good idea in reality. A thorough analysis should be done prior to going ahead with a QLAC or any other annuity product.
3. Working at Age 70 ½
If you are working at age 70 ½, you are not required to take RMDs from your current employer’s 401(k) — assuming you don’t own 5 percent or more of the company and your employer has made the election to allow this deferral of RMDs.
4. Roth IRA Conversions
IRAs are not subject to RMDs for you or for a spousal beneficiary who inherits the account. You might consider converting some or all of your eligible traditional IRA assets prior to the onset of RMDs.
Money converted to a Roth IRA is fully taxable in the year converted. The impact of these taxes paid now must be weighed against the tax savings down the road to determine whether or not this is a good strategy for you.
5. Inherited Roth IRAs and Roth 401(k) Accounts
Inherited Roth IRAs left to non-spouse beneficiaries and Roth 401(k) accounts are also subject to RMDs, though these distributions are not taxable. They do, however, lose the tax-free protection of the Roth umbrella. In the case of the Roth 401(k), it can be rolled over to a Roth IRA and it will get the same treatment.
With inherited IRAs, beneficiaries younger than 70 ½ might need to take RMDs if the original account owner was doing so prior to his or her death. But the beneficiary would take the RMDs based on his or her own age, allowing for smaller distributions and stretching the tax-deferred nature of the account for a longer period.
In a nutshell, if your are 70 ½ and don’t need your RMD, you should look at strategies to minimize the amount of the distribution or defer it and the accompanying tax hit.
These strategies should be viewed in the overall context of your retirement plan. Tax avoidance is, of course, a tactic and not an objective unto itself. (Tools like our calculators at NewRetirement.com can help you figure out your overall plan). And if appropriate for your situation, one or more of these strategies could help you avert the devastating impact that RMDs can have on your wealth.