Time to Read: 7 Minutes
Many high earners want to know what strategies they can implement to help reduce the tax burden caused from large, unwanted required minimum distributions (RMDs) in retirement. In Part 6 of a 7-part series, “Tax Saving Strategies for High Earners,” we break down what you need to know about RMDs and explain the strategies to maximize your savings today without causing excessive taxes from RMDs later.
How can I reduce taxes from required minimum distributions?
At BWM, we’ll evaluate the following strategies below to help reduce your RMDs and effectively lower your tax bill in retirement. It starts with creating a savings strategy today that will lower your RMDs later. If you’re retired, we’ll evaluate if it makes sense to take IRA distributions now or convert pre-tax IRA money to tax-free Roth investments. You can also reduce your RMDs without paying taxes by making a Qualified Charitable Distribution. It’s also a good idea to make sure the investment fees for your IRA aren’t being paid out of another account.
- Save proportionally between your retirement and non-retirement accounts – While putting all your savings into tax-deferred retirement accounts may provide a nice upfront tax benefit, it can cause a lack of control over your taxes in retirement. In fact, you may unintentionally end up in a higher income tax bracket in retirement because you’re having to recognize a certain amount of ordinary income each year through RMDs.At BWM, we’ll help you figure out how much to save and the best accounts to allocate your savings into. We’ll blend your 401(k) and other tax-deferred savings with strategies like backdoor Roth and Health Savings Account (HSA) contributions. These approaches allow you to save into retirement accounts that don’t have RMDs. You’ll get a tax deduction for your HSA contribution and can take tax-free distributions from your HSA to pay for qualified medical expenses in retirement.If your situation allows for it, we’ll also allocate a portion of your portfolio to investments like in-state municipal bonds and certain real estate funds that pay out tax advantaged income. Ultimately, we’ll set you up with an income strategy for retirement that smoothens out your taxes and gives you flexibility over how much income you want to recognize each year.
- Take qualified IRA distributions before age 72 – Starting at age 59.5, the IRS says you can take money from your tax-deferred retirement accounts without being subject to the 10% early withdrawal penalty. This means you’ll simply pay ordinary income taxes on your IRA distributions. Taking qualified IRA distributions in early retirement may be particularly useful if you’re in a lower tax bracket than you were while working but expect taxes to increase once RMDs kick in. By withdrawing IRA funds upon retiring, you may pay less in taxes than you would have otherwise paid had you waited until age 72. Over time, your qualified distributions will also reduce the size of your IRAs, resulting in lower RMDs at age 72 and beyond. On top of that, if the withdrawals from your IRA (and other sources of income) are sufficient to cover your costs in retirement, it might make sense to delay taking Social Security long enough to maximize your benefits. BWM can work with your CPA to evaluate the tax-efficiency of your income sources and determine how much you could withdraw from your IRAs before jumping into a higher tax bracket.
- Covert funds in your tax-deferred Traditional IRA to a tax-free Roth IRA –This is called a Roth Conversion. You would pay taxes now, but reduce unnecessary RMDs later, and build tax-free growth going forward.This strategy works well if you’re in a lower tax bracket in retirement than you were while working and don’t need IRA distributions to cover your living costs. For example, imagine you’re funding early retirement by spending down a large cash reserve and collecting income from tax-advantaged investments. This may leave you with a golden window of opportunity to make partial Roth conversions at a low tax rate each year until you turn 72. Before the end of each year, we can collaborate with your CPA to decide on the right amount of Traditional IRA funds to convert to Roth. Remember that Roth IRAs do not have RMDs during the original account owner’s lifetime, and distributions are tax-free anyways.
- Donate funds in your Traditional IRA directly to charity –If you’re at least 70.5 years of age, you can donate assets in your Traditional IRA directly to charity. This is called a Qualified Charitable Distribution (QCD) and it counts towards satisfying your RMD. The distribution is tax-free, so it doesn’t get reported as income on your tax return.This strategy works well if you’re charitable, even if your RMD isn’t more than what you need to cover your living costs. For example, rather than using your RMD to pay off your bills, you can cover those expenses with money from a taxable account and put your RMD towards a QCD. This is a way to move otherwise taxable money out of your IRA and receive a tax benefit for your charitable giving without having to itemize your deductions.
- Continue working full time – If you’re still working full-time at age 72, the IRS will allow you to suspend RMDs from your current employer’s 401(k) plan. While RMDs can’t be suspended from your previous employers’ 401(k) plans, you can get around that by rolling over any old 401(k)s into your current employer’s 401(k). This will help you defer RMDs from your 401(k) funds while you’re working and likely in a higher tax bracket than you will be in retirement. If you’re wanting to retire at age 72 and anticipate having a large salary that year, it may make sense to delay taking your first RMD until April 1st of the following year when you’ll be in a lower tax bracket. Even though this will mean you’ll receive two RMDs in one tax year (your 1st year RMD and 2nd year RMD), you may pay less in taxes overall by bunching these two RMDs in your first year of retirement.
Want a refresher on the basics? Read on…
What is a required minimum distribution?
A required minimum distribution (RMD) is the amount of money you must withdraw from certain retirement accounts each year once you turn age 72. RMDs generally apply to tax-deferred retirement savings. Contributions to these accounts are made with pre-tax dollars, and RMDs ensure that the government will ultimately receive the taxes due on these amounts.
You must pay ordinary income taxes on these withdrawals and if you fail to take your full RMD by the appropriate deadline, you may have to pay a 50% penalty tax on the difference between your RMD and the amount you withdrew.
Roth IRAs are generally exempt from RMDs because contributions are made with after-tax dollars. The IRS states you must take RMDs from the following accounts:
- Traditional, SEP, and Simple IRAs
- 401(k), 403(b), and 457(b) plans
- Profit sharing plans
- Other defined contribution plans
The amount of money you must take from your IRA each year is based on your age and the year-end balance of your account The IRS calculates your RMD by dividing the prior December 31st balance of your IRA by a life expectancy factor which can be found on the Required Minimum Distribution Worksheet published by the IRS. Generally, this means your RMDs will increase as you get older.
Once the specific RMD for each IRA has been calculated, you can total the sum of these RMDs and take them from any one or more of your IRAs. For example, imagine you have two IRAs each with a $50k RMD. Rather than withdrawing $50k from each IRA, you can simply take $100k from one IRA, and not withdraw any money from the other. This can be especially helpful if one of your IRAs holds an investment that is illiquid and can’t quickly be converted to cash.
How are required minimum distributions taxed?
RMDs are generally taxed at your ordinary income tax rate. There’s one exception to this general rule. You will not be taxed for any portion of an RMD that is a return of a non-deductible contribution. In other words, if you did not receive a tax-deduction in the year you contributed to your IRA because your income was too high, then you will not owe taxes on the portion of your RMD that is considered a return of your non-deductible contribution. However, you must file Form 8606 with the IRS in the year in which you make an after-contribution, and there are filing rules that must be followed to avoid double-taxation.
While making non-deductible IRA contributions may reduce your RMDs, it’s generally not a smart strategy. You won’t get a tax deduction for putting money in, the money you invest won’t grow tax-free, and you’ll have to calculate the portion of your RMD that is considered a return of your non-deductible contribution and shouldn’t be taxed. For these reasons, there are typically much better ways to save for retirement.
When must I start taking required minimum distributions?
You are subject to RMDs beginning in the year you turn age 72. You may delay taking your first RMD until April 1st of the year following the year you turn 72. But for each subsequent year, you must take your RMD by December 31st. So, if you turn 72 in June of 2022, you have until April 1stth of 2023 to take your RMD for 2022. But your RMD for 2023 must be taken by December 31st of 2023.
This means if you were to wait until April 1st to take your 2022 RMD, then both your 2022 and 2023 RMDs would be reported as income on your 2023 tax return. Doubling your RMDs in one tax year can create a higher tax bill and may cause some of your income to be taxed at a higher rate. For this reason, to smooth out your tax bill it’s generally better to take your first RMD by December 31st of the year you turn 72.
Can a distribution that exceeds my RMD for one year be applied to my RMD for a future year?
No, if you withdraw more than your RMD amount in one year you can’t apply your excess distribution towards your RMD for future years. In other words, you can’t take future years’ RMDs in the current year. For example, while it may be a tempting strategy to take next year’s RMD this year if you’re in a low tax bracket, IRS rules do not permit this.
Can required minimum distributions be rolled over into another tax-deferred account?
No, the IRS does not allow for RMDs to be rolled over into other retirement accounts, including a Roth IRA. That means you cannot simply take RMDs out of your IRA and reinvest the funds in another IRA. This leaves you with two options. You can either spend your RMD, or you can reinvest it in a non-retirement account like a trust.
The wrong savings strategy can lead to inconvenient and unavoidable tax consequences in retirement. Making decisions about how much to save, what accounts to save into, and how to invest your savings can be a complex and challenging process to handle on your own.
At BWM, we’ll review your full financial picture to help you create a savings strategy that’s best for your specific needs. If it’s projected that you’ll be subject to higher taxes in retirement because of unnecessary RMDs, we’ll help you implement tax-deduction strategies to lower your future RMDs and create a more tax-efficient income stream in retirement.