After years of focusing on building your retirement nest egg, being forced to start drawing it down can be disconcerting. But once you hit 70½, IRS rules call for required minimum distributions (RMDs) every year on all of your traditional, simplified employee pension (SEP) and SIMPLE IRAs, as well as employer-sponsored plans such as 401(k), 403(b) and 457(b) plans. Roth IRAs are exempt.
The IRS requires that you calculate an RMD separately for each IRA you own, but permits you to withdraw the total amount from one or more of your IRAs. The same formula applies to 403(b) plans – you must calculate the RMD separately for each 403(b) plan but can withdraw the total amount from one or more. However, RMDs for 401(k) and 457(b) plans have to be taken separately from each account.
Since you definitely want to comply (the IRS will levy a hefty 50% penalty on any amount you are supposed to withdraw but don’t), it’s a good idea to strategize with your advisor on how to be smart with RMDs, perhaps even automating them so you know you’re always in compliance. Don’t wait too long on this – you’ll want to have a plan in place well before the trigger age and may even choose to take preemptive distributions earlier while you still have control over the amount and timing of any withdrawals.
- RMDs are mandatory every year after age 70½, although you can delay taking the first one until April 1 of the year after you reach that age. If you do, be aware that you will need to take a second RMD in that same year and will owe taxes on both.
- RMDs are calculated according to an IRS formula called the Uniform Lifetime Table that is applied to the balance(s) in your IRA and other retirement accounts on December 31 of the year prior to the calendar year in which you take the distribution.
- You can have state and federal taxes automatically withheld from your RMDs.
Because RMDs essentially create a taxable income stream whether you want it or not, your planning is likely to center on coordinating that stream with other income sources such as Social Security and income generated by other assets. RMDs are also going to affect your overall tax liability and potentially your estate plans, so be sure to think about how everything interacts. What follows are possible scenarios and strategies you may want to consider.
SCENARIO 1: You want to take advantage of a low tax year or down market
STRATEGY: Convert traditional IRAs to Roth IRAs
If your income declines – or the market does – you may want to take the opportunity to convert a traditional IRA into a Roth IRA. You’ll owe taxes on the amount you convert in the year of the conversion, but unlike traditional IRAs, the balance in your new Roth IRA is not subject to RMDs – and any withdrawals you choose to make are not taxable*. You want to pay taxes at the lowest rate possible, so for example, if you are in the 15% tax bracket now but believe you will be in the 25% or higher bracket later on, you may be able to save on future taxes by paying taxes now by completing a Roth conversion. If you’re considering a conversion, be sure to determine whether the income created by the conversion will push you into a higher tax bracket for the year. You want to “fill up” a lower bracket but not wind up in a higher one, which potentially can generate issues with surcharges on Medicare premiums, Social Security taxes and certain Affordable Care Act subsidies. Be sure to consult with your advisor and tax professional before proceeding.
SCENARIO 2: You don’t need the money and want to minimize your taxes
STRATEGY: Make a charitable contribution from your IRA
If you want to reduce your RMD in a given year, you may want to consider what’s known as a qualified charitable distribution (QCD), which allows you to donate up to $100,000 directly from your IRA to a qualified charity. This removes money from your IRA tax-free, which in turn reduces the amount on which your RMD for that year is calculated, and also provides you with a potential tax deduction. You must be 70½ or older to be eligible to make a QCD.
SCENARIO 3: You need the money to live on and want to minimize taxes
STRATEGY: Consider purchasing an annuity within your IRA
If you’re counting on your retirement accounts to fund your living expenses indefinitely but also want to reduce your current tax bill, one possible strategy is to purchase what’s called a “qualified longevity annuity contract” (QLAC) in your IRA. With a QLAC, you pay a specified premium now in return for guaranteed income later in life. You don’t have to take an RMD from the portion of your IRA used for that premium until age 85, which may cut your current tax liability. The IRS exempts longevity annuity premiums of up to $125,000 or 25% of your IRA account, whichever is less. Traditional, SEP-IRAs, SIMPLE IRAs and 401(k) plans are eligible, as are 403(b) and 457 plans. Annuities can be complicated, so be sure to discuss any such purchase with your advisor.
Guarantees are subject to the claims-paying ability of the issuing insurance company.
These are just a few of the options available with RMDs; a financial advisor can help you create a specific plan that addresses your individual situation. As part of that, be sure to talk with a financial advisor about locating your investment assets strategically – holding some types of assets in taxable accounts and some in retirement accounts can make a difference come Tax Day.
If your spouse is your sole designated beneficiary and also is more than 10 years younger than you, your RMD may be determined based on a different formula that will generally result in a lower annual RMD.
RMDs are generally subject to federal income tax and are taxed as ordinary income. In some cases, they may also be subject to state taxes. However, distributions that reflect after tax contributions you made to your IRA may not be taxable.
With IRAs subject to RMDs, it may make sense to hold bonds or dividend-producing stocks** that can generate income you can earmark for withdrawals. Income is beneficial in these accounts because you don’t want to be forced to sell at an inopportune moment – RMDs are mandatory whether the account is up or down on Dec. 31. Taxable accounts are a good place to locate long-term growth investments that don’t generate income because long-term capital gains are taxed at favorable rates. Growth-oriented investments may also be suitable for your Roth IRAs.
The goal of the IRS with RMDs is to be sure that a steady stream of taxable money comes out of your retirement accounts. Your goal is to comply in a tax-efficient manner that also takes into account other income streams, your estate plans and, oh yes, the fact that you worked hard for that money and it’s time to enjoy some of it. With some wise planning, everybody can be happy.
* Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount is subject to its own five-year holding period.
** Dividends will fluctuate and are not guaranteed.
Raymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.
Material prepared by Raymond James for use by its financial advisors