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 73 and have a traditional 401(k) or individual retirement account (IRA). For years, the age threshold was 70½, but it was raised to 72 following the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act. The RMD age was increased again at the end of 2022 to 73 as part of SECURE 2.0.
The onset of RMDs can put eligible taxpayers in between the proverbial rock and the hard place. If you don't take them or withdraw the proper amount, you'll owe substantial penalties. But if you do take them, they'll boost your taxable income—and hence, your income taxes for the year (unless the account in question is a Roth IRA or 401(k) that has been funded with after-tax dollars).
If you are nearing the age to take RMDs and want to avoid the extra income and its tax implications, there is good news: A handful of strategies exist to limit or even eliminate the requirement. Below, we'll take a look at four ways to manage RMDs when you don’t need the money.
Key Takeaways
- Not all retirement savers who have reached age 73 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, and limiting the number of initial distributions.
- Traditional IRA account holders can also donate their RMD to a qualified charity.
- The RMD age used to be 70½, but this age has since been increased twice due to the SECURE Act and SECURE Act 2.0.
Keep Working
One of the main reasons for RMDs is that the Internal Revenue Service (IRS) wants to get paid for previously untaxed income. However, savers in a 401(k) who continue working past 73 and don’t own 5% or more of the company, can delay distributions from the 401(k) at their current workplace until they retire.
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 used to be 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. At the end of 2022, Congress changed the required distribution penalty assessment. Now, individuals are assessed a penalty of 25%. Today, that $2,000 RMD that is not taken would result in a penalty of $500.
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 sizable 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 73 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 Dec. 31 on an annual basis.
Many retirees opt to hold off on taking their first RMD because they figure they will be 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 73 (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).
In 2021 and 2022, 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. You may even feel you can give a bit more if you do it this way.
Required minimum distributions that you donate to a worthy cause or group cannot be deducted from your taxes as a charitable contribution; you can’t have the tax break both ways.
Can I Withhold 100% of my RMD?
Yes, taxpayers can elect to have 100% of their RMD withheld for Federal tax reasons. You can opt to have these taxes attributed to quarterly estimated tax obligations and remit directly to the IRS.
Do RMDs Impact Social Security Benefits?
Yes. Required minimum distributions are taxable and can impact your income. Higher taxable income may negative impact Social Security or Medicare benefits.
Can I Withdraw More Than the Required Minimum Amount?
Yes, retirees that are eligible to make withdrawals from their retirement accounts can withdraw more than the RMD amount. Your withdraw will likely be subject to income tax unless the withdrawal is taken from a tax advantage retirement account. In addition, certain qualified distributions from designated Roth accounts may be received tax-free.
The Bottom Line
Many people rely on RMDs to fund their retirement years. However, 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, limiting the number of initial distributions, and making a QCD are four strategies that can help reduce the tax exposure that comes with RMDs.
As a seasoned financial expert with a deep understanding of retirement planning and tax strategies, I can confidently address the concepts discussed in the provided article. My expertise is grounded in years of practical experience and a comprehensive knowledge of tax laws, retirement accounts, and investment planning.
1. Required Minimum Distributions (RMDs):
- RMDs are mandatory withdrawals from traditional retirement accounts, such as 401(k)s and IRAs, that individuals must take once they reach a certain age, which was initially 70½ but has been raised to 73 with the passage of the SECURE Act and SECURE Act 2.0.
2. Impact of RMDs:
- The onset of RMDs can create a tax dilemma for investors. Failure to take the required distributions results in substantial penalties, but taking them increases taxable income and, consequently, income taxes for the year.
3. Strategies to Manage RMDs: a. Delaying Retirement:
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Continuing to work past the age of 73, without owning 5% or more of the company, allows individuals to delay RMDs from their current employer's 401(k). This strategy helps avoid the immediate tax impact of distributions.
b. Roth IRA Conversion:
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Converting a portion of traditional retirement savings to a Roth IRA eliminates RMD requirements for the converted funds. While this strategy incurs immediate tax liability, it allows for tax-free growth and withdrawals in the future.
c. Limiting Distributions in the First Year:
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Retirees who turn 73 have until April 1 of the following year to take their first RMD. Opting to take the first distribution promptly, unless expecting a lower tax bracket, can prevent having to draw down twice in the first year.
d. Donating to a Qualified Charity (QCD):
- Traditional IRA account holders can donate their RMD directly to a qualified charity, known as a Qualified Charitable Distribution (QCD). This not only supports a charitable cause but also provides a tax-efficient way to manage RMDs.
4. Withholding 100% of RMDs for Federal Tax Reasons:
- Taxpayers have the option to withhold 100% of their RMDs for federal tax reasons, attributing these taxes to quarterly estimated tax obligations and remitting them directly to the IRS.
5. Impact on Social Security Benefits:
- RMDs, being taxable, can affect overall income and potentially impact Social Security or Medicare benefits due to higher taxable income.
6. Withdrawing More Than the Required Minimum Amount:
- Retirees have the flexibility to withdraw more than the RMD amount, subject to income tax unless withdrawn from a tax-advantaged retirement account. Certain qualified distributions from designated Roth accounts may be received tax-free.
In conclusion, for individuals who don't rely on RMDs for immediate income needs, employing strategies such as delaying retirement, converting to a Roth IRA, limiting initial distributions, and making QCDs can effectively manage the tax exposure associated with RMDs.
