Stocks and bonds have both taken a beating this year, but that can create an opportunity to save big on taxes for retirees who don’t need their required minimum distributions (RMDs) to live on. In other words, there’s a simple move you can make to limit what you owe the federal government on an RMD from your individual retirement account (IRA) or 401(k). Consider working with a financial advisor as you work to put a lid on taxes you pay.
A Primer on RMDs
RMDs are withdrawals you have to make from most retirement plans (excluding Roth IRAs) when you reach the age of 72 (or 70.5 if you were born before July 1, 1949). The amount you must withdraw depends on the balance in your account and your life expectancy as defined by the IRS.
To calculate your RMD, start by visiting the IRS website and access IRS Publication 590. This document has the RMD tables that you will use to calculate your RMD. Then, take the following steps:
- Locate your age on the IRS Uniform Lifetime Table
- Find the “life expectancy factor” that corresponds to your age
- Divide your retirement account balance as of Dec. 31 of the previous year by your current life expectancy factor
Morningstar explains how retirees who don’t need their RMDs to live on and who have seen losses in tax-advantaged accounts can protect capital gains from the IRS. The key is an in-kind transfer. This kind of transfer simply means that you move securities from one account to another account as-is. It can be from one taxable brokerage account to another such account. Or it could be from a tax-advantaged account, like an IRA, 401(k), 403(b) or SEP IRA, into a taxable brokerage account. There’s no selling off of securities and using the receipts to buy new ones. You’re keeping the securities and just changing where they are being “housed.”
For the purposes of retirees protecting capital gains in tax-advantaged accounts from the IRS, the specific in-kind transfer in view is from a tax-advantaged account into a taxable brokerage account.
Here’s How It Works
Assume you’re in the 32% tax bracket and you have to sell $50,000 of a depressed security out of your IRA to fulfill your RMD – and you don’t need the RMD to live on. You use a money market fund or money market account to pay the taxes on that $50,000, which comes to $16,000. A few years later those shares, which you kept in your IRA, rise to $80,000 and you sell them. You’ll owe taxes at a 32% rate on the $80,000, which amounts to a $25,600 tax bill.
But now assume that instead of hanging on to those shares, which have fallen in the first half of 2022 to $50,000 in your IRA, you do an in-kind transfer of those depressed shares into a taxable brokerage account. You pay the $16,000 tax bill from your RMD with a money market fund or money market account. A few years later those depressed shares rise to $80,000 and you sell them out of your brokerage account. Now, instead of paying a 32% tax on the whole amount ($80,000), you’d owe the 15% capital gains tax on the appreciation, which comes to $4,500 (15% of $30,000).
In other words, you have avoided $21,100 in taxes ($25,600 minus $4,500).
Sometimes a down market can be your friend. For example, if you’re a retiree who does not need his or her RMDs to live on and you have securities in a tax-advantaged account that has lost value, consider transferring them into a taxable brokerage account. That way after they rebound in value you will only pay a capital gains tax on the appreciated amount. If you keep those securities in your tax-advantaged account and then sell them after they have rebounded in value you’ll have to pay income tax at your normal rate, which ends up being much more than if you had done an in-kind transfer of these securities into a taxable brokerage account.
Tips on Taxes
- Tax planning is a key element in financial planning so consider working with a financial advisor to make the most tax-savvy moves. 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.
- Use SmartAsset’s free tax calculator to get a quick estimate of what you will owe the federal government.
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