Strategies to reduce taxes from Required Minimum Distributions
Tax planning is a key part of being a successful investor and consideration should be paid when planning around IRA Required Minimum Distributions (RMDs) in retirement. RMDs are minimum amounts that you must withdraw annually from your IRA once you have reached the mandatory age, which is based on when you were born. The SECURE Act of 2019 raised the age from 70 ½ to 72 after December 31, 2019. If you were born before July 1, 1949, distributions were required by April 1 of the year following when you turned 70.5. And if you were born on or after July 1, 1949, distributions are required by April 1 of the year following when you turn 72. The annual required withdrawal amount is based on the total account balance of your IRA as of December 31st of the prior year, divided by a distribution period outlined by the IRS life expectancy tables. As your age increases, the denominator gets smaller, meaning your distributions get larger each year, assuming a stable investment value. RMDs also apply to defined contribution plans, such as 401ks, but have slightly different rules, so for this article we will focus on IRAs.
RMDs create a bit of a tax conundrum. Not taking distributions results in a 50% excise tax on the amount not taken. And taking the income increases your taxable income, which increases your tax bill. There are several strategies that can be used however to reduce the tax implications.
- Once you reach the mandatory age, take your initial RMD by December 31. You can delay your first RMD to April 1 of the following year, however by delaying your first withdrawal, you will end up having to take two withdrawals that year, which could bump you into a higher tax bracket, especially if you will also have Social Security, pension, and other retirement income. It could also subject you to increased Medicare premiums. Medicare IRMAA (Income-Related Monthly Adjustment Amount) are increased premiums that high income earners pay for Medicare Part B and Part D benefits.
- Start taking withdrawals early. You don’t have to wait until your mandatory age, and you can take tax penalty free withdrawals from IRAs starting at age 59 ½. If you have significant IRA savings and your RMDs are likely to push you into a higher tax bracket, taking distributions early could help spread out your tax bill by reducing the IRA value for when RMDs are required. This strategy can also be helpful to fill an income gap if you have decided to delay claiming Social Security beyond full retirement age. Ed Slott, a CPA, and professor of practice at The American College of Financial Services, has suggested that the “M” in RMD instead stand for maximum. He contends that it may be advisable to take additional funds now, while we are in a low tax rate environment before taxes go back up when the 2017 tax cuts expire.
- Donate all or part of your RMD to a qualified charity. This is known as a Qualified Charitable Distribution or QCD. You are allowed to give up to $100,000 tax-free each year, which counts towards your RMD but isn’t included in your adjusted gross income. This can be a great way to lower your taxes, avoid added Medicare premiums, and support a charitable cause that you would have otherwise supported. And even though the Secure Act raised the RMD age from 70.5 to 72, the QCD age remains at 70.5, so you can still make a charitable donation even if your RMDs haven’t started. This strategy can lower your IRA balance, thereby lowering your future RMD amount.
- Convert money from a traditional IRA to a Roth. If you convert money from an IRA to a Roth, you will owe ordinary income tax on the conversion. However, after that, the money will grow tax free and won’t be subject to future RMDs. This strategy may make sense if you think you’ll be in a higher tax bracket when you eventually need the money or if you want to leave your heirs tax free money as Roth withdrawals aren’t subject to income tax. The first few years of retirement may be the sweet spot for timing as you want to do it when you are in a lower tax bracket (i.e., not receiving a salary) but before RMDs have started. Conversions can create issues with Medicare IRMAA so consider completing these prior to age 63 to avoid the Medicare 2-year lookback.
Given the complexities with these various strategies it’s advisable to consult with your accountant and Harbor team before implementing any of these strategies. Each person’s financial situation is unique and needs to be considered, which we can help you do.