A main benefit of 401(k) plans and individual retirement accounts is the ability to delay taxes on contributions and investment gains. However, you can’t avoid the tax man forever.
“Once you reach a certain age, the IRS wants to be able to begin collecting taxes,” explains Megan Slatter, a wealth advisor with Crewe Advisors in Salt Lake City.
The way the government does that is by mandating people take what are known as required minimum distributions, also called RMDs.
“It’s the minimum amount you have to withdraw without incurring a penalty,” says Mark Van Drunen, regional president of Northeast Ohio for MAI Capital Management.
RMDs begin at age 73, and the amount to be withdrawn is determined by a government formula. However, you can minimize your payments — and the taxes you owe — by following these tips for taking required minimum distributions.
— Begin planning years in advance.
— Convert to a Roth account.
— Start RMDs at the right age.
— Avoid two distributions in the same year.
— Delay 401(k) withdrawals if you are still working.
— Withdraw the correct amount.
— Be selective about how you take the distribution.
— Avoid taxes by donating your RMD to charity.
[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]
Begin Planning Years in Advance
The best way to avoid paying taxes on required minimum distributions is to minimize the amount of your RMDs. Doing that requires some planning.
“You don’t want to wait until the last minute,” says Nick Hughes, a wealth advisor with Visionary Horizons Wealth Management in Chattanooga, Tennessee. He generally recommends his clients begin their RMD planning at least five years out.
Strategies for minimizing required minimum distributions may include a combination of withdrawals and conversions to Roth accounts, which are not subject to RMDs. The goal is to even out annual tax obligations, according to Van Drunen, who recommends his clients start planning 10 years in advance.
“While it feels really good to pay only 10% in taxes, the next year you might get bumped into 24% (by RMDs),” he says. Tax forecasting can help even out those numbers as retirees take advantage of low tax years to move money out of traditional accounts and avoid higher taxes later.
Convert to a Roth Account
Planning early provides time to convert funds from traditional retirement accounts to Roth accounts. These accounts are funded with after-tax dollars, but they grow tax-free and money can be withdrawn tax-free after age 59½. There are also no required minimum distributions with Roth IRA accounts.
To convert money from a traditional retirement account to a Roth account, you must pay income tax on the converted amount. That’s why making a conversion during low income — and thereby low tax — years makes sense. For some people, these years may be at the start of retirement when they no longer have earned income and perhaps have not yet started Social Security benefits.
In the past, only Roth IRAs were exempt from required minimum distributions. That changes in 2024 when Roth 401(k) and 403(b) plans will no longer be subject to RMDs.
Start RMDs at the Right Age
For years, retirees were required to begin taking out RMDs at age 70½. Recent legislation has changed that, though.
“Over the past several years, they’ve pushed back the age,” Hughes says.
It was first bumped back to 72 as part of the SECURE Act. Then, with the passage of the Secure 2.0 Act, the starting age for required minimum distributions was changed to 73 in 2023. Ten years from now — in 2033 — the age will be further pushed back to 75, making it the RMD age for those born in 1960 or later.
If you fail to take the required minimum distribution, you’ll be assessed a 25% tax penalty in addition to regular income taxes on the distribution amount. For those who quickly correct the mistake and take out their RMD, the penalty may be reduced to 10%.
Beyond that, it is possible to request an abatement of the remaining penalty from the IRS, but “I’ve very rarely ever seen them do that,” Slatter says.
[SEE: 7 New Taxes Retirees Face.]
Avoid Two Distributions in the Same Year
When you turn 73, you have until April 1 of the following year to withdraw your first required minimum distribution.
“Generally speaking, this is a bad idea since now you’re taking two RMDs instead of one,” Van Drunen says.
That’s because the option to defer an RMD until April 1 is available only for the first year. After that, you’ll need to take an RMD each calendar year. For instance, if you are supposed to take your first RMD in 2023 but wait until the spring of 2024, you’ll end up withdrawing both your 2023 and 2024 distributions in the same year.
Depending on your retirement savings, that could mean a significant increase in your taxable income. Not only could it result in a higher tax bracket, but it may also trigger higher Medicare premiums.
Delay 401(k) Withdrawals if You Are Still Working
One exception to the RMD rule is for those who are still working at age 73. In that case, if you have a 401(k) at your current workplace, you don’t have to take minimum distributions from that account until after you leave the job.
This doesn’t apply to employees who own 5% or more of the company sponsoring their 401(k) account, though. It also doesn’t apply to 401(k) accounts from other employers or IRAs. However, if you want to avoid RMDs on these other accounts, you could roll the balances over to your workplace 401(k).
Withdraw the Correct Amount
How much you need to withdraw each year is based on a formula that divides your fund balance at the end of the previous calendar year by the IRS’s estimate of your remaining life expectancy. If you have a spouse who is at least 10 years younger and is the sole beneficiary of the account, a joint life expectancy is used. This can reduce your RMD amount.
While you can do the calculation yourself, many plan sponsors will do it for you. If your 401(k) or IRA doesn’t automatically provide you with the amount of your required minimum distribution, contact them at the start of each year to inquire about your fund balance and required withdrawal amount.
As its name suggests, the required minimum distribution is the smallest amount you can withdraw from your account each year to avoid a penalty. If you do withdraw more, be aware that the excess funds will not count toward the following year’s RMD, although they will reduce your fund balance and therefore reduce future required minimum distributions.
Be Selective About How You Take the Distribution
Once you must begin taking required minimum distributions, there is no way to get around withdrawing that amount. But you do have choices about when and from where you make a withdraw.
“We generally recommend taking it toward the end of the year so you’ll have almost the whole year of growth in your account,” Hughes says.
If you have multiple IRAs, you don’t have to make withdrawals from each account. Instead, you can calculate your total required minimum distribution and take it from whatever combination of IRAs that you’d like.
“I would look at the objectives of the underlying accounts,” Slatter says. For example, one of her clients has an IRA with a beloved charity as a beneficiary. When it is time to take the RMD, her money is withdrawn from another IRA to allow the account designated for charity to continue to grow.
Be aware that this is only an option for IRAs. You can’t bundle RMDs for workplace retirement accounts such as 401(k) plans. Individual distributions must be taken from each of these accounts each year.
[READ: How to Pay Less Tax on Retirement Account Withdrawals.]
Consider Making a Qualified Charitable Distribution
If you don’t need the money from your required minimum distribution, you can avoid taxes by donating it to a qualified charity. Known as a qualified charitable distribution — or QCD — this can be a particularly good option for those who don’t itemize deductions on their tax return.
While Congress changed the age for required minimum distributions, they left the age for QCDs the same. That means, starting at age 70½, you can use this option to donate up to $100,000 per person to qualified charities each year.
“We use those before (age 73) to reduce the inevitable required minimum distributions,” Van Drunen says.
The money needs to go directly from your IRA to the charity to qualify. What’s more, workplace retirement plans like 401(k) accounts aren’t eligible to make qualified charitable distributions. There are some other tax rules that may also apply to your situation, so consult with a financial professional for more details about this strategy.
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How to Take Required Minimum Distributions originally appeared on usnews.com
Update 08/15/23: This story was published at an earlier date and has been updated with new information.
