Holders of individual retirement accounts (IRAs), 401(k)s and other qualified retirement accounts are required to commence taking distributions from those accounts at age 70½. The rationale is that they were allowed to make contributions that were tax-deferred and the balances in these accounts grew tax-free. This is the case even where after-tax contributions were made.
Required minimum distributions (RMDs) force the account holder to take a taxable distribution that is based on the account balance at the end of the prior year and their age. The logic is that government wants to collect taxes for all of that tax-deferred growth and the original tax-deferral and that the investor will be in a lower tax bracket in retirement. As to the latter, that may or may not be true. Some retirees do not need the cash flow from these RMDs and would prefer to minimize them and the resulting tax bill. Here a few strategies. (See also: How to Calculate Required Minimum Distributions.)
Taking Distributions Prior to Age 70½
Financial advisors should monitor their client’s tax bracket in the years prior to the commencement of RMDs. If their taxable income is relatively low during their early years of retirement, it could make sense to take distributions from these tax-deferred accounts at a level that will fully utilize the client’s current tax bracket. This will have the added benefit of reducing the value of these accounts and will result in a lower RMD calculation down the road, all things being equal.
Roth IRA Conversions
Converting all or part of a traditional IRA account to a Roth IRA will serve to reduce the amount of the traditional IRA account that is subject to RMDs down the road. This strategy can be employed at any point, but it takes planning. Anyone interested in doing this would be wise to consult with a knowledgeable financial or tax advisor before proceeding as there are income taxes due on the amount converted and the conversion process can be complicated. (See also: Avoiding Mistakes in Required Minimum Distributions.)
One strategy might be to look at converting during years where the client’s income is lower than usual. A spin on this might be to look at the client’s income during their early years of retirement if their income is relatively low.
Contribute to a Roth 401(k)
If your company’s 401(k) plan offers the option, consider designating all or some of your salary tax-deferrals to the Roth option in the plan. These contributions are made with after-tax dollars, but the contributions grow tax-deferred. If rolled to a Roth IRA upon leaving, the employer will never require a minimum distribution or incur the associated income tax hit.
This is something that will likely be done years prior to even considering the potential impact of RMDs, but financial advisors would be wise to consider this for clients who look like they will accumulate significant sums in traditional IRA and 401(k) accounts. There are other considerations while the client is working and the potential future tax savings may be trumped by other tax and financial planning considerations. (See also: An Overview of Retirement Plan RMDs.)
Working at 70½
For those who are working at age 70½, their 401(k) or similar defined contribution plan with their current employer may be exempt from RMDs. They cannot be a 5% or greater owner of the company, and only this retirement account qualifies. Further, this is not an automatic plan feature. Their employer’s plan must adopt this provision. If this is something a client might be considering, it behooves them to ask their employer to adopt this if it is not already included in their plan. Clients might be eligible to roll balances from prior 401(k) plans into an applicable plan to avoid RMDs.
Ideally, if the client anticipates working past 70½, they will have been rolling old 401(k) balances into the plans of new employers throughout the years if their new plans allow for this. This assumes that the new plans are a good option from an investment standpoint in each case. Even if money from old 401(k) plans had been rolled over to an IRA, the old rules prohibiting that money to be rolled into a new employer’s 401(k) plan if it had been comingled have been changed. Reverse rollovers from an IRA to a 401(k) plan are allowed as long as the IRA money was all contributed on a pre-tax basis, and the 401(k) plan sponsor allows it. (See also: How Much Should Retirees Withdraw From Accounts?)
None of this eliminates the need to eventually take RMDs from this account, but the RMDs can be deferred until the client no longer works for the company when they presumably will be in a lower tax bracket.
Qualified Charitable Distributions
Qualified charitable distributions (QCDs) do not serve to reduce the amount of the RMD per se, but this technique does reduce the IRA account holder’s tax liability from the RMD. This allows all or part of the RMD up to $100,000 to made payable directly to a qualified charity. This deduction applies to IRAs only and not to qualified retirement plans like a 401(k). The amount donated to the charity is not included in the account holder’s income but is also not eligible for a charitable deduction on top of this. Additional rules apply so those interested would be wise to consult with a knowledgeable tax or financial advisor. (See also: Retirement Plan Solutions for 70+ Workers.)
Consider a QLAC
"Consider" is the operative word as qualified longevity annuity contracts (QLAC) are a relatively new wrinkle in the retirement planning arena. Legislation passed in 2014 allows a portion of the balance of a traditional IRA, 401(k), 403(b) or 457 plan to be used to purchase a QLAC and is exempt from RMDs. This annuity would provide a deferred benefit that must commence by age 85 and is limited to $125,000 or 25% of the account balance. While this is a strategy to reduce your RMD, the critical question to answer is whether or not a QLAC is a good choice for part of your retirement assets. (See also: Longevity Annuities Arrive in 401(k) Plans.)
The Bottom Line
Required minimum distributions may not be desired by some retirees. There are a number of valid strategies to reduce the amount of a client’s RMD that a financial advisor might suggest. As with any strategy, the overall impact on the client’s situation should be considered, not just the tax savings from reducing the RMD. (See also: Retirement Portfolios: Adding Crucial Alternatives.)