Just like getting older, required minimum distributions (RMDS) are a part of life for investors who have reached 70-and-a-half-years old and have money stored in a traditional 401 (K) or individual retirement account.
For most savers, paying taxes on their distributions is an accepted necessary evil because they need the money to live off. However, wealthy retirees who have a sizeable nest egg may want to hold off.
For those investors nearing the 70-and-a-half-year-old mark who don’t want to take required minimum distributions, there’s good news: a handful of strategies exist to eliminate the requirement and/or manage it. From converting to a Roth IRA to delaying retirement, here’s a look at three ways to manage RMDs when you don’t need the money.
Keep on Working
One of the main reasons for RMDs is that the Internal Revenue Service wants to get paid for previously untaxed income. But for savers in a 401 (K) who continue working past 70-and-a-half and don't own 5 % or more of the company, the plan may enable them to delay distributions from their 401 (K) until they retire. The rule only pertains to a 401 (K). If you have an IRA or a 401 (K) from a past employer, you will have to follow the RMD rule once you hit 70-and-a-half or face the excess accumulation tax, which is 50% of the required distribution that you were supposed to take but didn’t. Let’s say your RMD was $2,000 but you decided against withdrawing that amount. You’ll be on the hook for $1,000 in taxes. (Read more about important retirement plan RMD rules.)
Convert to a Roth IRA
An effective strategy for wealthy savers looking to avoid drawing down required distributions is to roll over some of their savings to a Roth IRA. Unlike a traditional IRA or Roth 401 (K), which require you to take annual distributions after age 70-and-a-half, a Roth IRA doesn’t require any distributions at all. That means the money can stay in the Roth IRA for as long as you want or it can be left to heirs. Contributing to a Roth IRA isn’t going to lower your taxable income, but you don’t have to pay taxes on withdrawals if you are over 59-and-a-half, 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.
Donating to a Charity Can Lower Your Tax Bill
Some savers, particularly wealthy ones, would rather see their money go for good than to the government. And one way to do that with an RMD is to make a charitable contribution. If the contribution is $100,000 or less and is rolled out of the retirement account and directly to the charity, you won’t have to pay an RMD tax. The charity has to be a qualified one to get the break.
Limit the Number of Distributions in a Year
A big knock against RMDs are the taxes investors have to pay as a result of drawing down some of their retirement savings. After all, it can potentially push a retiree into a higher tax bracket which means more money going to Uncle Sam. Retirees who turn 70-and-a-half have until April 1 of the calendar year after they reach that age to take their first distribution and then they have to take it on an annual basis by Dec. 31.
Many retirees opt to hold off on taking their first RMD because they figure they will be retired, which means a lower tax bracket. While holding off makes sense for many it also means you will have to take two distributions in one year, which means more income the IRS will tax. That, in turn, could 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 70-and-a-half unless you expect to see your tax bracket fall a lot to prevent having to draw down twice in the first year. (Read more about tax tips on Roth and regular 401 (K)s.)
The Bottom Line
For many people, RMDs aren’t a big deal because they need their retirement savings to live off. But for wealthy savers or those who have a lot of money in non-retirement savings vehicles, limiting the tax exposure from RMDs is the name of the game. Whether they choose to delay retiring, convert some into a Roth IRA or limit the number of initial distributions, all three ways are designed to reduce some of the exposure that comes with this government requirement.