Individual Retirement Accounts (IRAs), 401(k)s and other workplace plans can help you build wealth for the future while enjoying some tax benefits. There’s just one important thing you need to plan for: required minimum distributions (RMDs). The IRS requires you to begin taking distributions from certain retirement accounts beginning at age 72. Applying some smart RMD strategies can help you to reduce distributions and lower your tax bill.
A financial advisor could help you create a financial plan to reduce your taxes in retirement.
What Are Required Minimum Distributions?
Required minimum distributions or RMDs are amounts you’re obligated to withdraw from certain tax-advantaged retirement plans. The types of accounts that are subject to RMDs include:
- Traditional IRAs
- SEP IRAs
- SIMPLE IRAs
- 401(k) plans
- 403(b) plans
- 457(b) plans
- Profit-sharing plans
- Other defined contribution plans
Roth IRAs don’t have any RMDs so you can leave money in those accounts as long as you live. But anyone who inherits your Roth account will have to take minimum distributions.
Generally, RMDs begin at age 72. More specifically, the IRS says you must start taking them by your required begin date (RBD). The required begin date is April 1 of the year following the year in which you turn 72. So if you turn 72 on Oct. 5, then your RMDs must begin starting on April 1 of the next calendar year.
The amount you’re required to withdraw is based on your account balance and life expectancy. Withdrawals are taxed at your ordinary income tax rate. Failing to take RMDs on schedule can result in a 50% tax penalty.
RMD Strategies to Reduce Taxes
Taking RMDs can be problematic from a tax perspective. If you have large balances in your IRAs or workplace retirement accounts, taking required minimum distributions could significantly inflate your tax bill. That’s where it pays to have a few RMD strategies in your back pocket to try and reduce what you owe.
Here are six common ways to shrink your RMDs in order to minimize taxes:
1. Draw Down Your Account Early
Once you turn 59 ½, you can begin taking money from retirement accounts without a tax penalty. Taking larger distributions in the early years of your retirement can reduce your overall account balance, lowering your RMDs later. This option could make sense if you expect to be in a lower tax bracket when you retire.
Drawing down your retirement accounts before age 72 can offer another benefit. You may be able to delay taking Social Security benefits. The longer you delay benefits beyond your full retirement age, the more your benefit amount increases. If you can wait up until age 70, for example, you’ll receive 132% of your benefit amount.
2. Consider a Roth IRA Conversion
Roth IRAs offer the benefit of 100% tax-free qualified withdrawals and they don’t have RMDs. If you’d like to avoid required distributions altogether you could convert your traditional retirement funds to a Roth account. You will have to pay tax on the conversion in the year that it occurs. But it may be worth it to take a one-time tax bill hit in order to avoid RMDs and be able to withdraw remaining retirement funds tax-free.
3. Work Longer
If you have some of your retirement funds in your current employer’s 401(k), you might consider working longer to avoid RMDs. As long as you’re still working in some capacity, you’re not required to take minimum distributions from a workplace plan where you’re still employed.
That exception doesn’t apply to retirement accounts you had with previous employers. You won’t get a pass on IRA RMDs either. But continuing to work could help to reduce the total amount of RMDs you need to take once you turn 72. And again, you can delay Social Security benefits as well.
4. Donate to Charity
One of the most popular RMD strategies for avoiding taxes involves donating the amount to charity. The IRS allows you to donate up to $100,000 a year from an IRA without having to pay income tax. The money you withdraw will still count toward your RMD so you don’t have to worry about a 50% tax penalty for failing to take distributions.
There are a few rules for this strategy:
- You can only donate up to $100,000 to a qualified charity
- Your IRA custodian must arrange for the transfer of funds to an eligible charity
- You’re not allowed to claim the donation as a charitable deduction your taxes
You might consider this option if you don’t necessarily need all of the funds in your IRA and you’d like to support a good cause in retirement.
5. Consider a Qualified Longevity Annuity Contract
A qualified longevity annuity contract or QLAC is a type of deferred annuity contract. You can use your retirement funds to purchase the annuity, then receive payments back at a later date. Payments are required beginning at age 85 and any money you put into the annuity does not factor into your RMD calculations.
There is, however, a catch. You can only put so much money into a QLAC. For 2022, you can contribute up to 25% of your retirement account balance or $145,000, whichever is less. While you can defer taking payments until age 85, you can’t avoid them indefinitely.
6. Check Your Beneficiaries
If you’re married and there’s a sizable age gap between you and your spouse, you might have another option for reducing RMDs. When you’re 10 years or more older than your spouse and name them as the sole beneficiary of your retirement account, you can use the IRS Joint Life and Last Survivor Expectancy Table to calculate RMDs.
This strategy allows you to use your spouse’s longer life expectancy to determine how much to withdraw, which can lower the amount. Of course, if your spouse is closer to your own age or you have multiple beneficiaries, you wouldn’t be able to use this RMD strategy.
Applying RMD strategies can be a simple way to reduce what you owe in taxes during retirement. You can use just one strategy or apply several in order to bring down your tax bill. Just keep in mind that with the exception of a Roth IRA conversion, there’s no way to avoid RMDs indefinitely.
Retirement Planning Tips
- Consider talking to your financial advisor about different RMD strategies that might be appropriate for your retirement planning situation. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve 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.
- A backdoor Roth IRA is also something to consider if your income is too high to contribute to a Roth account directly. The IRS limits who can contribute to a Roth IRA based on filing status and modified adjusted gross income. But you can convert traditional retirement account funds to a Roth account. Again, you will have to pay taxes on the conversion at the time it’s completed but you might consider this option if you expect to be in a higher tax bracket when you retire.
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