One factor that retirees too often overlook when tax planning in retirement is the legislation surrounding Required Minimum Distributions (RMDs).
When you retire, you must consider the pace at which you draw down your retirement accounts in order to give your savings the best chance of outlasting your retirement. Included in this consideration are questions like: how might my income needs change over the course of my retirement? And how will my taxes be affected by which retirement accounts I access and when I do so?
To accurately answer these questions, it’s important to understand RMDs. In this article, we will discuss the most important things you need to know about RMDs and how they can affect your retirement plan and your taxes.
What is the Required Minimum Distribution?
The Required Minimum Distribution (RMD) is the minimum amount of money you are required to take out of certain retirement accounts each year. These accounts can include:
- Traditional IRAs
- SEP IRAs
- SIMPLE IRAs
- 401(k) plans
- 403(b) plans
- 457(b) plans
- profit-sharing plans
- other defined contribution plans
Currently (as of 2021), the RMD regulation applies to anyone who holds one or more of these accounts (please note that the RMD rules do not apply to Roth IRAs) and is 72 years or older.
If you miss an RMD deadline or elect not to withdraw, the money will be taxed quite heavily. Refusing to withdraw at least the required amount will result in a 50 percent tax of the amount that should have been withdrawn.
Of course, as the name implies, the Required Minimum Distribution is the absolute minimum you need to withdraw from these accounts without facing any penalty. You can – though probably shouldn’t – withdraw as much as you please.
RMD rules vary slightly by retirement plan. You can learn more here.
To calculate the minimum amount you’ll be required to withdraw, you will need to take your account balance as of December 31st of the previous year and divide it by your life expectancy factor. Once you make the withdrawal, it will be taxed as ordinary income.
The IRS has two worksheets available to help retirees calculate their RMDs.
What RMDs Mean for Your Retirement Tax Strategy
Essentially, the RMD creates a situation in which you must withdraw or face severe tax consequences.
However, withdrawing can itself have unintended tax consequences. Because your withdrawals count as ordinary income, if you don’t account for RMDs when planning your annual retirement income, you may find yourself in a tax bracket you weren’t prepared for.
For this reason, it’s important to connect with your financial advisor at the beginning of the year to plan your retirement income and account for RMDs.
How to Avoid RMDs
There are a number of reasons why you might want to avoid RMDs. Perhaps you are still working and aren’t yet prepared to tap your retirement accounts. Perhaps you are eager to give your savings the opportunity to continue growing.
No matter the reason why you choose to do so, avoiding RMDs is possible. One of the easiest ways to avoid the RMD is to convert one or more of your current accounts to a Roth IRA. Because money is taxed when it is added to a Roth account and not when it is withdrawn, you can make voluntary withdrawals at your leisure without worrying about taxes once the account has been created.
Using or converting to a Roth IRA isn’t your only option to avoid RMDs. You can also choose to simply make the withdrawals and put the funds into another account—just because you’ve withdrawn the money doesn’t mean you need to spend it. For those that want to safely carry their savings forward while still accumulating some value, a Certificate of Deposit (CD) or government-backed bonds may be appealing options. For those that are willing to accept some more risk in exchange for growth, investing in stocks, real estate, or other speculative markets might also be appealing.
Lastly, if you are charitably inclined and have reached the age of 70 ½, you may be able to use your qualified retirement funds to make charitable gifts. This is referred to as a Qualified Charitable Distribution (QCD). By taking advantage of a QCD you will not only be able to fulfill your RMD for that tax-year, but you will also be able to avoid paying any income tax on that portion of pre-tax money all together. Using a QCD is a valuable option to not only give back to your charity of choice but also reduce your income taxes and fulfill the mandatory RMD requirements.
All of these, or none of these, RMD avoidance options may be a viable strategy for your personal situation. That is why we recommend you meet with your financial advisor to clearly outline the best RMD strategies based on your personal income, tax, and estate planning needs.
Recent Developments for RMDs
Several laws have recently affected RMDs. Among the most notable changes was raising the age requirement from 70½ to 72 years old.
In March 2020, as part of the broader COVID-19 relief package, all RMDs were suspended for the year. This meant that if individuals wanted to leave their funds in their accounts, they could do so without penalty. However, the law was not extended into 2021, meaning that the RMD regulation is “back on.”
Additionally, The SECURE Act, passed in 2019, modified how inherited IRAs are regulated. The new regulation eliminated the previous “stretch” loophole that allowed some people to extend the tax-deferred feature of their IRA into an inheritance.
Advanced Retirement Strategies and Your Retirement Tax Plan
Tax planning in retirement arrives with a host of new challenges, rules, and opportunities.
Planning all of this on your own can be overwhelming, since there are so many complicated factors to consider. Working with a financial advisor can give you access to the help and guidance you need to make the right choices to fully enjoy your retirement.
The financial advisors at Advanced Retirement Strategies have decades of combined experience helping clients transition into retirement. Using sound investment strategies, extensive social security knowledge, and calculated tax strategies, Advanced Retirement Strategies provides resources and services to residents of Bountiful, Utah and the surrounding area who are eager to make the most of their retirement years.
If you are within ten years of retirement and have over $250k in assets, click here for a free retirement review from Advanced Retirement Strategies to gauge the efficiency of your investments, income plan, and tax strategies.