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How to Avoid Taxes on RMDSaving for retirement in a 401(k) at work or a traditional individual retirement account (IRA) can help you build wealth for the long term while enjoying some tax advantages. Beginning at age 72, you’re required to take minimum distributions (RMDs) from those accounts, which means you won’t be able to defer paying taxes on earnings indefinitely. That could mean a sizable tax bill if you’re in a higher tax bracket in retirement. If you’re wondering how to avoid taxes on RMD payouts, there are some strategies you can use to minimize them. A financial advisor can offer significant benefits as you work to avoid taxes in retirement.

What Are Required Minimum Distributions (RMDs)?

Required minimum distributions, or RMDs, are amounts you’re required to withdraw from certain tax-advantaged accounts upon reaching age 72. Those accounts include traditional and Roth 401(k)s as well as traditional IRAs.

The amount you have to withdraw as a minimum distribution depends on your account balance, life expectancy and other factors. The Internal Revenue Service uses a formula to determine how much individual taxpayers are required to withdraw, though it’s up to you to make sure you’re withdrawing the correct amount. Your withdrawals would then be taxed at your ordinary income tax rate.

Failing to take required minimum distributions on time can be problematic, as it can trigger a large tax bill. The IRS can impose a penalty of 50% of the amount you must withdraw if you fail to make your RMDs on schedule.

How to Avoid Taxes on RMDs by Working Longer

One of the simplest ways to defer RMDs and the taxes on those withdrawals is to continue working. If you’re still working at age 72 or beyond and contributing to an employer’s 401(k), the IRS allows you to delay taking RMDs from those accounts.

This only works for your 401(k) at your current employer, however. If you have a 401(k) from a previous employer, then the RMD rule would still apply. The same is true for any traditional IRAs you contribute money to.

Whether it makes sense to continue working to delay RMD taxes depends on a variety of factors, including your health, retirement goals and overall financial situation. If you enjoy your job and have no serious health issues that prevent you from doing it, delaying retirement might make sense for you.

Avoiding Taxes on RMD Payments by Donating to Charity

How to Avoid Taxes on RMDAnother possibility for delaying or minimizing taxes on RMDs is donating some of your distributions to a qualified charity. Qualified charitable distributions, or QCDs, allow you to transfer money from an IRA to an eligible nonprofit organization. These distributions aren’t taxable but they still count toward satisfying your required minimum distributions for the year. You can donate up to $100,000 from your IRA as a QCD to avoid taxes if:

  • Your IRA custodian agrees to transfer the funds to your chosen charity on your behalf. (You can’t make the donation directly.)
  • You don’t claim that donation as a charitable deduction your taxes.

If you’re not sure whether a charity is qualified, the IRS has a tool you can use to check its status. Keep in mind that this tax-minimizing tactic only works for IRAs; you can’t use this strategy to donate RMDs from a 401(k).

Minimize RMD Taxes With a Roth Conversion

Roth IRAs can be an attractive option for saving for retirement if you want to minimize taxes. Qualified distributions from Roth IRAs are 100% tax-free and there are no required minimum distributions at all.

If you have assets in a tax-deferred account, you could avoid RMDs and their associated taxes by rolling the balance into a Roth IRA. This is done through a Roth conversion in which you essentially turn tax-deferred assets into tax-free ones.

This is something your brokerage can help with but there’s one important caveat to know. Converting a traditional IRA to a Roth IRA doesn’t mean you can escape taxes completely. You’ll owe ordinary income tax on any assets that you roll over. That could mean a large tax bill for the year in which you complete the conversion.

But you wouldn’t have to take RMDs starting at age 72, so it may be a worthwhile trade-off. Your financial advisor can help you weigh the pros and cons of using a Roth conversion to minimize RMD taxes.

Consider an Annuity to Avoid RMD Taxes

How to Avoid Taxes on RMD

Annuities can provide you with a guaranteed stream of income in retirement. When you purchase an annuity, you’re purchasing an insurance contract. You pay premiums to the annuity company and the annuity company then makes payments to you beginning at a later date.

Qualified Longevity Annuity Contracts (QLACs) are one possibility for deferring RMD taxes. You can use the money from your 401(k) or IRA to purchase the annuity, omitting that amount from your required minimum distribution calculations. The maximum amount you can contribute to a QLAC is $135,000.

You don’t have to begin receiving payments from the annuity until age 85. At this point, they’d be subject to income tax. This strategy doesn’t eliminate the need to pay taxes on retirement income entirely but it can help you defer RMD tax payments for quite a while.

If you’re interested in a QLAC, it’s important to understand what you’ll pay and what your returns will look like. It’s also helpful to carefully research annuity company ratings. Choosing an annuity company that has questionable financials, for example, could backfire if the company isn’t able to make your annuity payments back to you when the time comes. This is something else you could discuss with your financial advisor if you’re unsure where an annuity might fit into your financial plan.

Bottom Line

Required minimum distributions can increase your tax liability in retirement. However, with some careful planning, there may be ways to reduce what you owe. Considering one or all of these methods is a good starting point for how to avoid taxes on RMD payments. Although, you should also consider other ways in which your tax situation could change. For example, working while also drawing Social Security benefits could have tax implications. Looking at the bigger tax picture can help you fine-tune your approach when managing retirement assets and income.

Tips for Investing

  • Consider talking to a financial advisor about all the possible ways to minimize your retirement tax liability. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you’re considering a Roth IRA conversion, make sure you’re observing the five-year rule. This rule states that your Roth IRA must be open for at least five years to avoid tax penalties. If you’re opening a Roth IRA for the first time to receive converted traditional IRA funds, make sure you won’t need to tap that money for at least five years. Otherwise, you could add to your tax liability rather than reducing it.

Photo credit: ©iStock.com/eggeeggjiew, ©iStock.com/katleho Seisa, ©iStock.com/FG Trade

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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