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Top Strategies for Avoiding Taxes on Your RMDs

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How to Avoid Taxes on RMD

Saving 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. But you’re obligated to take taxable withdrawals from your retirement accounts at age 73 as part of what’s called required minimum distributions (RMDs). (The SECURE 2.0 Act, which went into effect Jan. 1, 2023, pushed back the RMD age from 72 and also scheduled more RMD delays over the next 10 years). 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 help you build a retirement income plan. Speak with an advisor today.

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 73 (previously it was age 72). Those accounts include many popular retirement accounts such as 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. In fact, the IRS can impose a penalty of 50% of the amount you were required to withdraw if you fail to make your RMDs on schedule. If you’re required to take RMDs then you might be interested in the best strategies to avoid large tax bills, which we highlight below.

1. 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 73 or beyond and contributing to an employer’s 401(k), the IRS allows you to delay taking RMDs from those accounts.

Unfortunately, this only works for your 401(k) at your current employer. 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 that you contribute money to.

Do you need help figuring out your required minimum distributions? Try SmartAsset’s RMD calculator to learn more.

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. However, you may want to first consult with a professional to help you make the right decision.

2. Donating to Charity

How to Avoid Taxes on RMD

Another 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 without being taxed. While these distributions aren’t taxable 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 donate directly.)
  • You don’t claim that donation as a charitable deduction on your taxes.

If you’re unsure 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).

3. Minimize RMD Taxes With a Roth Conversion

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. 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.

Your brokerage can help with a conversion, but you should keep in mind that 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 you complete the conversion.

The benefit is that you wouldn’t have to take RMDs starting at age 73, 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.

4. Consider an Annuity

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, which then makes payments to you 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

  • When considering ways to reduce your tax liability, you may want to speak to a financial advisor who can help navigate you through the best scenarios. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel 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 reduce it.

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