Holders of individual retirement accounts (IRAs), 401(k)s, and other qualified retirement accounts are required to take distributions from those accounts beginning at age 70½. These 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 behind requiring distributions is that the government wants to collect taxes for all of that tax-deferred growth (as well as the original tax-deferral) and that the investor will likely be in a lower tax bracket during 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, as well as the resulting tax bill. Here are a few strategies to consider.
Taking Distributions Prior to Age 70½
Financial advisors often monitor their client’s tax bracket in the years prior to the commencement of RMDs. If taxable income is relatively low during the 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 the retirement accounts, which 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 can 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 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.
- Holders of qualified retirement accounts must take required minimum distributions (RMDs) beginning at the age of 70½.
- Individuals want to consider any changes in tax status when deciding the optimal strategy for taking distributions from retirement accounts.
- One strategy is to take greater distributions during the years when the individual is in a lower income tax bracket.
- Converting plans to Roth IRAs can reduce RMDs down the road, but the conversion process can be tricky.
- Those working past the age of 70½ are sometimes exempt from RMDs.
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 and the associated income tax hit can be avoided.
Converting to Roth retirement accounts is something that will likely be done years prior to even considering the potential impact of RMDs. It takes some planning. There are other considerations while you are still working—the potential future tax savings may be trumped by other factors such as tax and financial planning.
Working at 70½
For those working at age 70½ or beyond, the 401(k) or similar defined contribution plan with their current employer may be exempt from RMDs, provided that the individual does not own 5% or more of the company. In addition, only 401(k) retirement accounts qualify for this exemption and it is not an automatic plan feature—the employer’s plan must adopt the provision. Therefore, it sometimes behooves people to ask their employer to adopt the provision if it is not already included in their plan. In addition, employees might be eligible to roll balances from prior 401(k) plans into an applicable plan to avoid RMDs.
Ideally, if an individual anticipates working past 70½, they have been rolling old 401(k) balances into the plans of their newest employers throughout the years (if their new plans allow for this). Of course, all of this assumes that the new plans are a good option from an investment standpoint.
None of this eliminates the need to eventually take RMDs from this account, but the distributions can be deferred until the individual moves into a lower tax bracket when they no longer work for the company.
Qualified Charitable Distributions
Qualified charitable distributions (QCDs) do not serve to reduce the amount of the RMD, but the technique can reduce the IRA account holder’s tax liability from the distributions. The rules allow all or part of the RMD (up to $100,000) to be made payable directly to a qualified charity. The deduction applies to IRAs only and not to qualified retirement plans like a 401(k).
Since additional rules apply, those interested in leveraging qualified charitable distributions for tax purposes would be wise to consult with a knowledgeable tax or financial advisor.
A major benefit of the QCD strategy is that it can significantly lower the IRA account holder’s adjusted gross income and can have additional benefits in other areas such as the cost of Medicare Part B.
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 RMDs, the critical question to answer is whether or not a QLAC is a good choice for part of your retirement assets.
The Bottom Line
Required minimum distributions may not be desired by some retirees, but there are a number of valid strategies to reduce RMD amounts after the age of 70½. Important factors to consider are changes in income tax brackets, potential employment opportunities after the age of 70½, and the type of retirement plan options that are available before and after required minimum distributions begin.