Is there a way to limit the impact of required minimum distributions (RMDs)? They are a part of life for investors who have reached age 72 and have a traditional 401(k) or individual retirement account (IRA). This age used to be 70-1/2 but was raised to 72 following the passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act. With the onset of RMDS come higher taxes, unless you strategize carefully.
If you are nearing the age to take RMDs and you don't want to take them and pay income taxes on them, there is good news: A handful of strategies exist to limit or even eliminate the requirement.
Here’s a look at four ways to manage RMDs when you don’t need the money.
- Not all retirement savers who have reached age 72 and have a traditional 401(k) or IRA need the money from RMDs.
- There are a number of ways to reduce—or even get around—the tax exposure that comes with RMDs.
- Strategies include delaying retirement, a Roth IRA conversion, or limiting the number of initial distributions.
- Traditional IRA account holders can also donate their RMD to a qualified charity.
One of the main reasons for RMDs is that the Internal Revenue Service (IRS) wants to get paid for previously untaxed income. But for savers in a 401(k) who continue working past 72 and don't own 5% or more of the company, the plan may enable them to delay distributions until they retire. Note that this exemption only applies to your 401(k) at the company where you currently work.
If you have an IRA or a 401(k) from a previous employer, you will have to follow the RMD rule. Not taking a distribution means you'll face the excess accumulation penalty, which is 50% of the required distribution. If, for example, your RMD is $2,000 and you don't take it, you'll be on the hook for $1,000.
Convert to a Roth IRA
Another strategy for wealthy savers looking to avoid drawing down required distributions is to roll over some of their savings into a Roth IRA. Unlike a traditional IRA or Roth 401(k), which require RMDs, a Roth IRA doesn’t require any distributions at all. That means the money can stay—and grow tax-free—in the Roth IRA for as long as you want or it can be left to heirs.
Contributing to a Roth IRA won't lower your taxable income, but you don’t have to pay taxes on withdrawals from earnings if you are over 59½, and you have had the account open for five years or more. Investors who have a mix of money in a Roth IRA and traditional retirement savings accounts can manage their taxes more effectively.
Be aware, though, that moving pre-tax money from a retirement account into a Roth IRA means you have to pay taxes all at once on those funds. Roth conversions can be expensive, whether you're moving money from a 401(k) or a traditional IRA. Investigate your options in detail with your tax advisor.
For most retirement savers, paying taxes on distributions is a necessary evil because they need the money, but affluent retirees with a sizeable nest egg may want to hold off if they can find a way to avoid taking them.
Limit Distributions in the First Year
A big knock against RMDs is the taxes investors have to pay as a result of drawing down some of their retirement savings. This can potentially push a retiree into a higher tax bracket, which means more money going to Uncle Sam. Retirees who turn 72 have until April 1 of the calendar year after they reach that age to take their first distribution. After that, they must take it by December 31 on an annual basis.
Many retirees opt to hold off on taking their first RMD because they figure they will in a lower tax bracket when they retire. While holding off makes sense for many, it also means you will have to take two distributions in one year, which results in more income that the IRS will tax. This could also push you back into a higher tax bracket, creating an even larger tax event.
Here's a better option: Take your first distribution as soon as you turn 72 (unless you expect to end up in a significantly lower tax bracket) to prevent having to draw down twice in the first year.
Donate Distributions to a Qualified Charity
Some savers, particularly wealthy ones, would rather see their money go to a good cause than give some of it to the government. Traditional IRA account holders can donate their RMD to a qualified charity. This is known as the qualified charitable distribution (QCD) rule. It does not apply to a 401(k).
If the contribution is $100,000 or less—and is rolled out of the IRA and directly to the charity—you won’t have to pay taxes on the RMD. In order to get the tax break, the charity has to be deemed qualified by the IRS. This is a good way to save on paying taxes as you donate to a charity that would otherwise have gotten a donation from your regular savings accounts. You may even feel you can give a bit more if you do it this way. (Note that money donated this way cannot be deducted from your taxes as a charitable contribution; you can't have it both ways.)
The Bottom Line
Many people rely on RMDs to fund their retirement years. But for those who don't need the money, limiting the tax exposure from RMDs is the name of the game. Delaying retirement, converting to a Roth IRA, or limiting the number of initial distributions are three strategies that can help reduce the tax exposure that comes with RMDs. Making a QCD is a fourth.