Minimum distributions required. These three words can cause consternation, worry and apprehension in many people. Minimum distributions, or RMDs for short, apply to retirement savings you hold in a 401(k), 403(b), 457(b) or tax-deductible Individual Retirement Account (IRA), including SEP and SIMPLE accounts. As the name suggests, RMDs are not optional. Because you contribute pre-tax dollars to these accounts, or for IRAs, get tax relief for the contributions you make, at some point the chickens come home to roost – the IRS will get its go.
Managing RMDs can be confusing as the amount changes every year depending on your age, the value of the funds in your account and your life expectancy. Your account administrator can send you an annual notice regarding your RMDs and can even calculate the amount for you. Whether this happens or not, you are obligated to take your RMDs on time each year once you reach the age of 72. You can calculate them using an online calculator like this one, or use those from the IRS, brokerage firms, or mutual funds. supplier websites.
One of the reasons RMDs can cause frustration is that the extra income can push people into a higher tax bracket. In a way, it’s a nice problem to have. If you really need that income, paying more taxes on it isn’t a bad compromise. But, if you don’t need your RMDs to cover your living expenses, you’d rather have more control over how and when to take them, or you’re worried about how large withdrawals from your investments from retirement will affect your finances, the tax impact may seem more onerous.
While you can’t avoid RMDs, you can manage them. Here are five ways to make the most of your RMDs, including using them to fund your living expenses, reinvesting them in an after-tax account so they continue to grow, and donating them to benefit loved ones.
1. Delay, delay, delay
Working longer means you can delay some of your RMDs. However, you don’t get an absolute pass. If you are still working at age 72 and contributing to a pre-tax pension plan offered by your employer, you will not have to withdraw any RMD from that account as long as you continue to work and are not an owner. You will still be on the hook for RMDs from your other pre-tax retirement accounts such as those from previous employers.
2. Consider a Roth backdoor
Doing a Roth conversion with assets you have in pre-tax retirement accounts is one way to reduce the number of your assets that will be subject to RMDs. Since Roth accounts are funded with after-tax dollars — money you’ve already paid taxes on — these accounts aren’t subject to RMDs. This means that you decide when and how you will take distributions from these accounts, not from the IRS.
You need to know two things in advance. First, if you want maximum flexibility, consider doing so before you start taking RMDs. If you wait until you reach age 72 to convert, you must first take your RMD before you can convert any remaining funds in that account to Roth. Second, no matter when you convert, you will have to pay taxes on the funds you withdraw. This is because you were initially not taxed on these funds or, for the funds you invested in a tax-deductible IRA, you received a tax deduction.
Pro tip: If you want to do a Roth conversion, timing it to a year when your income is below normal or your portfolio has taken a hit can help reduce the tax bite. You will want to work with your tax specialist and financial adviser if you have one, so that you are fully aware of the tax impact.
3. Deposit your RMD amount into your spouse’s retirement account
If you’re married and your spouse is younger than you, you can use RMD funds that you don’t need for living expenses to make sure your spouse makes the maximum allowable contribution to their retirement account. Doing this can:
- reduce your combined taxable income, helping to partially offset the tax impact of your RMD
- give these funds more time to grow
- may mean you will be in a lower combined tax bracket when your spouse has to start taking RMDs
4. Fund A 529
Do you have grandchildren or other loved ones whose education you would like to help support? If you don’t need your RMDs, you can contribute them to a 529 plan. Combine that with “bundling” or “superfunding” – combining multiple years of contributions into one tax year – and you may be able to -be reducing your federal taxes (this only applies to taxpayers who itemize their returns).
Pro tip: Many states offer a tax deduction on contributions to their 529 plans.
5. Spread out your RMDs
You must take RMDs on a schedule and according to a calculation set by the IRS. But, you don’t need to withdraw them in a lump sum. Spreading your RMD out in quarterly or even monthly payments throughout the year instead of a single block at the start or end of the year has advantages. You can plan and make adjustments more easily by taking periodic payments than if you took your annual amount all at once.
Another big reason not to take your withdrawal all at once? Financial markets fluctuate. There is no way to predict when or for how long markets will go up or down. Research has consistently shown that missing even a few of the most profitable days in the stock market can have a significant negative impact on your investment returns. Spreading your RMDs out over the year reduces the chances of you cashing in just before a run in the markets or just after they crash.
Pro tip: If you don’t need your RMD, consider treating it as an in-kind transfer. This means that you make the withdrawal from the account without cashing out the investment. Just transfer it from your retirement account to a taxable investment account. You will still have to pay tax on your withdrawal, but you don’t have to sell an investment just to meet your RMD requirement.
Ultimately, your RMDs are the fruit of your decades of working. They should allow you to spend your retirement years doing things that give you pleasure.