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You can maximize tax savings with required minimum distributions (RMDs)

by Alliance America
August 25, 2023


One of the certainties to go along with the privilege of saving in a tax-advantaged retirement account is that eventually, the government wants its cut, which is the tax money you've been deferring. If you don't take these distributions or if you miscalculate them, you could end up paying more in taxes.

The proper navigation of required minimum distributions (RMDs) can be a crucial component of retirement planning, potentially saving thousands in unnecessary tax outlays.

What are RMDs?

wooden blocks that spell RMD stcked on top of a graph

RMDs are minimum amounts that the federal government requires retirees to withdraw annually from their tax-deferred retirement accounts, such as traditional IRAs and 401(k)s, once they reach age 73. These mandatory withdrawals are then subject to taxation, as they represent deferred income and earnings.

How can I take RMDs and minimize taxes?

If not withdrawn strategically, RMDs can push retirees into a higher tax bracket. This is especially true for those who have accumulated significant sums in their qualified retirement accounts. By carefully planning the timing and amount of these distributions, retirees can reduce the risk of moving into a higher bracket.

Failing to withdraw the correct RMD amount results in a hefty penalty – up to 50% of the amount you were supposed to withdraw but didn't. This can translate to a substantial sum, particularly if the oversight or miscalculation is significant. Money that remains invested often has the potential to grow. If you can minimize the amount you're required to withdraw from your retirement accounts by tactically managing your RMDs, this allows a larger portion of your investments to continue to benefit from potential market growth, thereby possibly increasing your retirement savings.

While these distributions are inevitable, the associated tax implications can be strategically minimized with advance planning. Advance planning for RMDs is like charting a course through a financial maze; every decision can lead to a different outcome. By understanding the intricacies of the tax code, being aware of income shifts and considering charitable tendencies, retirees can strategically position themselves for a more favorable tax scenario. The ultimate goal is a retirement journey with minimized tax burdens and maximized financial flexibility.

One strategy is to consider withdrawing more than the minimum amount during lower-income years or moving funds to a Roth IRA, which does not have RMDs. This can reduce the balance of the retirement account, thus potentially reducing the size of future RMDs and the related tax implications.

A fundamental step in RMD planning is to comprehend where these distributions will place you in the tax bracket spectrum. Being on the cusp of a higher tax bracket can significantly affect the amount you owe. If you're currently in a lower tax bracket and anticipate being pushed into a higher one due to RMDs, consider making withdrawals up to the limit of your current bracket. This ensures you're paying tax at a lower rate now rather than a higher rate later.

How are Roth conversions taxed?

One of the most effective tax-saving strategies is converting a traditional IRA to a Roth IRA. Though you'll pay taxes on the conversion amount, Roth IRAs are not subject to RMDs, and qualified distributions are tax-free, especially if you anticipate being in a higher tax bracket in the future or believe tax rates will rise. Over time, this can mean significant tax savings. By converting portions of your traditional IRA to a Roth IRA over several years, you can spread out the tax burden.

When you convert funds from a traditional IRA to a Roth IRA, you are essentially moving money from an account with pre-tax contributions to an account with post-tax contributions. Therefore, the amount you convert is treated as taxable income in the year of the conversion.

For example, if you convert $50,000 from a traditional IRA to a Roth IRA and are in the 22% tax bracket, you would owe an additional $11,000 in taxes (22% of $50,000) for that tax year.

While the converted amount is taxable, the conversion itself is not subject to the 10% early withdrawal penalty, even if you're below the age of 59½. However, this exemption from penalty only applies to the converted amount and not to any earnings on that amount if withdrawn before the age of 59½ and before having the Roth IRA for at least five years.

The attractiveness of a Roth conversion largely depends on your current tax rate versus your anticipated future tax rate. If you expect to be in a higher tax bracket in the future, paying taxes now at a lower rate and converting to a Roth IRA might make sense, as you can benefit from tax-free withdrawals later. If you expect to be in a lower tax bracket in the future, it might be more beneficial to delay the conversion or not convert at all, as paying taxes upon withdrawal might amount to a lower total tax bill.

You don't have to convert the entire amount in your traditional IRA to a Roth all at once. Partial conversions allow you to spread the tax burden over multiple years, and by strategically deciding how much to convert each year, you can potentially avoid pushing yourself into a higher tax bracket.

It's important to factor in other sources of income in the year you’re considering a Roth conversion. Other significant income sources, such as Social Security, can impact your overall tax rate, possibly making a conversion less beneficial in a specific year.

Post-conversion, there's a five-year waiting period before earnings from the converted amount in the Roth IRA can be withdrawn tax-free. This rule applies separately for each conversion and begins on January 1 of the year the conversion occurs.

What is the ideal age to start my RMD?

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The ideal age to start taking required minimum distributions (RMDs) is the age at which you can afford to do so without jeopardizing your retirement income. There is no one-size-fits-all answer, as the ideal age will vary depending on your individual circumstances. You typically must start taking RMDs in the year you turn 73. However, there's a grace period: You can delay your first RMD until April 1 of the year after you turn 73. It may seem tempting to delay, but doing so means you'll take two distributions in one year, potentially pushing you into a higher tax bracket.

Some factors to consider when deciding when to start your RMDs include:

  • Your expected retirement income: If you have a healthy retirement income from other sources, you may be able to delay your RMDs. However, if you expect to rely heavily on your retirement savings, you may need to start taking RMDs sooner.
  • Your health: If you are in good health, you may be able to delay your RMDs. However, if you have health problems, you may need to start taking RMDs sooner to ensure that you have enough money to cover your medical expenses.
  • Your investment goals: If you are saving for a specific goal, such as a child's education or a down payment on a house, you may need to start taking RMDs sooner to avoid outliving your money.
  • Your tax situation: The amount of your RMDs will be taxable, so you need to factor in the tax implications when deciding when to start taking them.

As mentioned, the penalty for not withdrawing enough in your RMD is steep: 50% of the amount you should have withdrawn (the amount will be reduced to 25% or 10%, if corrected, effective for tax year 2023). Each retirement account's RMD is calculated separately, but if you have multiple traditional IRAs, you can aggregate the total and withdraw from one or more of them. However, you can't aggregate RMDs from different account types.

Tax-efficient investing is another consideration. You can place investments that generate more taxable income (like bonds) in tax-deferred accounts and tax-efficient investments (like index funds or stocks you plan to hold long-term) in taxable accounts. This allows for a balance between taxable and non-taxable income in retirement.

Another tax strategy is to utilize qualified charitable distributions. For those inclined toward philanthropy, QCDs can be an avenue to reduce taxable income.

You can use direct donations to a qualified charity instead of taking an RMD. You can donate up to $100,000 annually from your IRA to a qualified charity without it counting as taxable income. The distribution must be made directly from the IRA custodian to the charity. This not only satisfies the RMD requirement but also removes the RMD amount from taxable income, as the money never touches your personal accounts.

Understanding the entirety of your income in retirement is crucial, but it’s a balancing act. If there are other significant income sources in a particular year (for example, selling a property or receiving an inheritance), consider this in tandem with your RMDs. It might make sense to adjust your strategy to ensure these inflows don't inadvertently push you into a higher tax bracket.

If you're still working past the age of 73 and don't own more than 5% of the company you work for, you might not need to take RMDs from your current employer’s 401(k). Money can remain invested in the 401(k) with your current employer until you retire, potentially delaying tax implications.

The bottom line is this: RMDs, if not handled with foresight, can lead to unnecessary tax burdens. However, with advance planning and an understanding of the intricacies involved, you can strategically manage your RMDs to optimize your retirement finances. It's important to consult with a financial professional to ensure you're making the best choices for your individual circumstances.

Alliance America can help

Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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