What You Need To Know About Required Minimum Distributions (RMDs)
In my career as a financial advisor, I’ve had hundreds of conversations with near-retirees and retirees. As people think about retirement, one of the topics I get questions about most often is Required Minimum Distributions (RMDs). In today’s blog, I’ll start by answering some of the most common questions about RMDs, as well as provide the best strategies to minimize their impact.
What is an RMD?
The year in which you turn age 72, the IRS requires you to start withdrawing a certain amount of your IRA each year. If you do not withdraw this amount by the end of the year, you will have to make the late withdrawal, pay ordinary income tax, and pay a penalty (a 50% excise tax on the amount of the withdrawal). You can learn more about the specifics on the IRS’ RMD webpage.
What accounts are subject to RMDs?
Traditional IRAs, SEP IRAs, SIMPLE IRAs, and in many cases, defined contribution plans (401k, 403b, 457, etc.) are subject to RMDs. On the other hand, Roth IRAs are exempt from RMDs! There are some cases where a 401k could be exempt as well (more on this later).
How much will I have to withdraw?
The institution where you hold your account will calculate the RMD amount for you. There is an IRS table for calculating distribution amounts, which will be based on your account balance and life expectancy. However, as a rule of thumb, the first year’s RMD amount is typically around 4% of the account value. Over time, the percentage of your withdrawal will increase until your passing or the account is depleted.
How do I make the RMD?
RMDs have the same process as a normal withdrawal from your retirement account. You will receive a 1099-R tax form as proof that you made the distribution. The amount of the withdrawal will be added to your income for the year and taxed at ordinary income rates.
How do I minimize the impact of RMDs?
There are several ways to strategically minimize the impact of RMDs on your tax and financial plan. They are:
1) Utilize Qualified Charitable Deductions (QCDs)
QCDs are the most powerful and widely applicable strategy to minimize the impact of RMDs. With a QCD, you can elect to send your RMD directly to a qualified charity or church organization. When doing this, you completely remove the RMD amount from the calculation of your income for the year. This is especially significant for those who take the standard deduction and do not have enough itemized deductions to get a tax benefit for charitable donations otherwise.
2) Convert Pre-Tax to Roth
Roth conversions are another profound strategy in financial and tax planning, particularly when it comes to the consideration of RMDs. Since Roth IRAs are not subject to RMDs, the more you have in Roth IRAs, the less you will be required to distribute from your retirement portfolio every year. This can have a profound impact on your lifetime tax bill. Remember, performing a Roth conversion means paying the income tax now so that you don’t have to pay it later. Therefore, Roth conversion strategies are complex and have a lot of moving pieces to ensure that you do not end up paying more tax by converting. Work with a financial planner and tax professional to do this effectively!
3) Create a Strategic Income Plan
A strategic income plan is critical to any successful retirement plan. What is a strategic income plan? It’s the how, where, and when of drawing income from various income sources throughout retirement in the most advantageous way. For example, a strategic income plan might prioritize drawing income from a Traditional IRA before taking Social Security and RMDs. This can be a profound way to keep your lifetime tax bill as low as possible.
4) Reinvest RMDs
Many people view RMDs as a spending bonus! At Redeem Wealth, we believe it’s critical to enjoy retirement and plan for extra spending on the things that are most important to you. However, unplanned spending of RMDs can lower lifetime asset values and potentially hinder your ability to meet your goals. In some cases, it makes sense to take your RMD and reinvest into a taxable brokerage account to keep your assets invested and help fight inflation.
5) Roll Into Your 401k
Another strategy that can be valuable is to take advantage of the RMD exemption in active 401k plans. The scenario is this: You are still working at age 72 with an active employer-sponsored retirement plan, and your 401k plan allows active employees to be exempt from RMDs (check your plan documents or work with your advisor to determine if this applies to you). In this case, it would likely be highly beneficial to rollover any outside pre-tax accounts (such as a Traditional IRA, SEP IRA, SIMPLE IRA, or other 401ks) into your active 401k plan. That way, you will not be forced to take RMDs and pay ordinary income tax on those distributions in addition to your wages from employment.
If you have questions about RMDs or how to apply these strategies to your specific situation, please schedule an appointment with our team of financial planners and tax professionals here at Redeem Wealth. We would love to help you prepare and plan for RMDs!
