Understand required minimum distributions and how to strategize to reduce taxes and make the most of your retirement accounts.
You spend your working years tucking money away for retirement. But the same accounts that gave you a tax break when you contributed have likely been growing over the years. That’s a good thing, until Uncle Sam wants his share. At age 72, you must start taking out required minimum distributions, or RMDs, and pay regular tax on the withdrawals.
While you can’t skirt the law, there are a variety of ways to optimize your position. But first, you need to know the basics. The 2019 SECURE Act upped the age when RMDs start from 70.5 to 72. Now, you must make the first withdrawal by April 1 of the year after you turn 72, and then by December 31 of every year thereafter.
This law generally affects the original owner of a traditional IRA, SEP IRA, and/or SIMPLE IRA. In addition, it applies to employer retirement plans such as 401(k)s and 403(b)s. It does not affect Roth IRAs because you paid tax on those funds before they were deposited.
RMDs are taxed at the ordinary income tax rate, not as capital gains. It’s usually best to take your first RMD in the year you turn 72 and not wait until the next year, when you would have to take two RMDs that may push you into a higher tax bracket. Compare your tax bills under each scenario before deciding what to do. Remember that higher income could also alter how much of your Social Security income will be taxed and the cost of Medicare Parts B and D.
Calculating Your RMD
To arrive at your RMD, the IRS divides your account balance on December 31 from the previous year by the life-expectancy factor based on your birthday. Luckily, you can just use a calculator or have your brokerage do this for you.
If you own more than one IRA, you need to add them up and figure out your RMD based on the total amount. However, you can withdraw that amount any way you’d like, taking it from just one account or from several. Owners of 401(k)s, on the other hand, must calculate RMDs and withdraw from each account separately.
You have the option of getting the withdrawal in a lump sum, or spreading out payments over the year — quarterly, monthly, or whatever works for you. Just make sure that the total is taken out by the deadline, or you will owe some incredibly stiff penalties: 50% of the shortfall plus income tax. The IRS may forgive you if you can offer up an explanation and how you corrected your mistake. File Form 5329 to ask for leniency.
An easier way to avoid this punishment is to have your account custodian manage withdrawals.
Avoiding RMDS: Work Waiver, Roth Rollovers and Conversions
One way to avoid taking RMDs at 72 is if you are still working and don’t own over 5% of the company. In that case, you don’t have to take RMDs on your current employer’s 401(k), but you will still need to make withdrawals on other retirement accounts.
If your current 401(k) allows rollovers from other 401(k) plans from previous employers, it’s a great strategy for not paying taxes until you actually retire. Note that IRAs cannot be rolled into a 401(k).
An easy solution for Roth 401(k) owners is to roll those funds into a Roth IRA, which doesn’t require the original owner to make RMDs. If you have a Roth IRA account that is at least five years old and you are 59.5 or older, the money rolled into the account (and any gains) is yours tax-free.
If you own both traditional and Roth IRAs, another smart strategy is to convert all or some of your traditional funds to a Roth IRA. This is typically best in years when you have lower income, so it’s often done over time between retirement and age 72, although there is currently no age limit. Of course, you’ll have to pay taxes on the amount converted, but future RMDs will be lowered. All Roth distributions are tax-free, so if you need extra money, you can access these funds without increasing your taxable income. If you retired before 65 and have health care through the Affordable Care Act, remember that rollovers count toward your adjusted gross income (AGI) and may affect subsidies you receive.
Qualified Longevity Annuity
You may want to use a qualified longevity annuity, or QLAC, to lower RMDs and defer the related tax. These deferred annuities don’t pay out right away, but it is not as expensive as an immediate annuity. You can invest up to $130,000 or 25% of your balance, whichever is less. The money invested in the QLAC is no longer taxable, but payouts, which usually start at about age 85, are.
If you own company stock in your 401(k), then you may be able to take advantage of a tax strategy known as net unrealized appreciation. Roll all of the funds out of the 401(k) and into a traditional IRA but put the stock into a taxable account. You’ll have to pay ordinary income tax on the cost basis of the stock, but future profits realized at a sale will qualify for lower capital gains taxes. In addition, your RMDs will be lower since the company stock is no longer included.
The IRS makes an exception to the traditional formula for RMDs for those with a spouse more than 10 years their junior. The life-expectancy factor is adjusted by using the intersection of the age of both spouses in Table II of IRS Publication 590-B or just check the appropriate box on the calculator.
If you’ve reduced your RMD as much as possible but still have excess funds, put them in a taxable brokerage account. Tax-efficient investing options include municipal bonds and index funds.
Your RMD does not have to be made in cash. Consider directing your broker to transfer a portion of it in stock to a taxable account, where the date of transfer value becomes the basis. This is particularly valuable in a down market where you can avoid locking in a loss. Of course, if the stock continues to decline you can at least harvest the loss.
Starting at age 70.5, qualified charitable donations (QCD)s allow transfers of up to $100,000 annually to a charity or charities directly from the IRA. They will count toward the RMD but will not appear in adjusted gross income. This is an especially useful tactic for taxpayers who don’t itemize and would otherwise not be able to write off contributions.
But it can also benefit itemizers by lowering AGI so that they can take advantage of, for example, the write-off for medical expenses that exceed 7.5% of AGI.
Yes, you can use your RMD to manage tax payments. Tell your brokerage to withhold an amount of money from your RMD to equal your entire tax bill for the year. You won’t have to hassle with quarterly payments or worry about underpayment penalties. Even if you have your RMD withdrawn as a lump sum in December it’s not a problem because the IRS considers withholding to be evenly paid throughout the year. And if you wait until December, you’ll have a better idea of what you’re going to owe.
RMDs may be unavoidable but they can be effectively managed. Be sure to consult a tax professional before you make any changes to your accounts.