If you’ve built substantial savings in your tax-advantaged retirement accounts, you may become a victim of your own success. Once you begin your required minimum distributions (RMDs), your savings prowess could result in much higher income taxes and Medicare premiums than anticipated. However, if you plan ahead, you can minimize or even prevent these unexpected retirement expenses.
An RMD is an amount you must withdraw each year once you turn 73. The following retirement plans have RMDs:
- IRAs: Traditional, SEP, and SIMPLE
- Traditional 401(k), 403(b), and 457 plans
- Roth 401(k), 403(b), and 457 plans
- Profit-sharing plans
The deadline for taking your annual RMD is December 31. However, you can delay taking your first RMD until April 1 of the year after you turn 73. Remember, if you do this, you’ll have to take your first and second RMD in the same year, possibly resulting in more income taxes than if you took both in different years.
If you work past 73, you still have to take an RMD from your IRA, but you can delay taking RMDs from your current employer-sponsored retirement plan if you’re still working at 73 and do not own more than 5% of the business you work for. However, you must be employed throughout the entire year to qualify for the exception.
RMDs Are Not Required for Roth IRAs or 401ks
Roth IRA, SIMPLE, SEP, and 401k are fantastic. Besides all qualified withdrawals being tax-free, they do not have RMDs. You can leave the Roth account untouched until the cows come home, save it for an emergency, leave it to your heirs, or donate it to charity after you’re gone.
Calculating Your RMDs
To determine your RMD, divide your tax-deferred retirement account balance as of the previous December 31 by your life expectancy from the IRS Uniform Lifetime Table.
For example, John is 76. On December 31 of last year, his 401k balance was $800,000. According to the IRS Uniform Lifetime Table, John’s life expectancy factor is 23.7. He divides $800,000 by 23.7 to get $33,755.27. That is the minimum amount John must withdraw from his 401k.
The Younger Spouse Calculation
If your spouse is more than 10 years younger than you, you have to use the Joint Life Expectancy Table.
In this table, your life expectancy is based on your and your spouse’s ages.
For example, Mary, age 78, is married to Steve, age 67. Her IRA balance was $600,000 on December 31 of last year. According to the Joint Life Expectancy Table, the divisor is 22. By dividing the balance by 22, Mary’s RMD is $27,272.72.
There are several variables for RMDs, and most times, you won’t have to calculate your RMDs on your own. Your advisor or the company holding your retirement account will typically calculate for you. However, it’s always a good idea to double-check. Take a look at IRS Publication 590 to learn more.
The RMD penalty
If you didn’t withdraw your full RMD by December 31 (or April 1, in the year of your first RMD), you would be subject to a 25% penalty, and if the mistake is corrected during a two-year “correction window,” the penalty is further reduced to 10%.
If your annual RMD were $40,000, but you only took out $20,000, you would be charged a 25% penalty on the $20,000 difference and owe $5,000 in addition to your regular income tax due. Or, if you were still within the two-year correction window and took the RMD, you could reduce the penalty to 10% or $2,000.
Strategies to manage your RMDs
If significant RMDs could be a part of your future, this, of course, is an excellent problem to have. It means you’re able to save a substantial amount for retirement. There are four planning strategies you need to focus on to prevent unintended retirement consequences.
- Retirement account diversification
- Roth Conversions
- Retirement Income Planning
- The gifting option
Account Diversification
We talk about investment diversification, but you also need retirement account diversification. You can have too much of a good thing, which also applies to your retirement accounts. If you do a bang-up job of saving 100% of your retirement savings in a 401k, then 100% of your retirement savings will be subject to RMDs. Your options are limited. You should expand your retirement savings with the following:
- Roth Accounts: IRA or 401k/403b
- Brokerage Account
- Non-qualified annuity (maybe)
These accounts have different tax repercussions both before and during retirement. The right mix of account types can provide options and tax-saving opportunities in retirement.
The Roth IRA accounts will create tax-free distributions in retirement. The brokerage account will be subject to taxable interest, dividends, and capital gains but not income tax at each withdrawal. The non-qualified annuity is a mix of taxable and non-taxable distributions. Although I’m not a big fan of annuities, they do have their place and, in some instances, could be a good option. If you’re maxing everything out and have significant brokerage account savings, they really come into play – then it’s time to think about a low-cost, variable, non-qualified annuity.
It is a balancing act between your current tax situation and your future projected retirement tax liabilities. Throw in tax laws that change occasionally – it’s a continual game of cat and mouse.
Roth Conversions
Yes, this is just a different way to diversify your retirement savings. If the timing and your situation are right, Roth Conversions may be an appropriate tax-saving way to reduce future RMDs and allow your investments to grow tax-free.
There are numerous factors regarding when and how much to convert to a Roth IRA. You have to analyze to ensure the benefits outweigh the cost of converting. To learn more, see our post Learn how to implement a Roth Conversion Effectively.
Retirement Distribution plan
You take the account diversification strategy and possible Roth conversion strategy, put them to work, mix in your Social Security benefit, and develop a retirement income recipe. At this point, the possibilities are endless.
If you’re retired and meet all other qualifications, you can begin to withdraw money from your retirement accounts penalty-free. Should you take all from the tax-deferred (IRA/401k/403b), all from the tax-free (Roths), or your brokerage (capital gains tax), or should you take a little from each?
Social Security: When will you and your spouse take social security? Will you or your spouse take it early, at your full retirement, age 70, or somewhere in between?
That’s the beauty of account diversification. You can do whatever is best for you. You have options. You can change it up yearly (other than the Social Security decision) based on your needs and tax laws. To learn more, check out Reduce Your Retirement Risk with an Effective Retirement Distribution Strategy before it’s too late.
Qualified Charitable Distribution (QCD)
You have a few options if you don’t need RMDs for living expenses. You might move the RMD to a taxable investment account, although that doesn’t avoid the income tax due. Another option is to donate the RMD directly to the charity with a Qualified Charitable Distribution (QCD).
The QCD is when funds are sent from your qualified retirement account directly to your favorite charity, and even though this is a distribution, it is not taxable to you. It is a simple strategy that can have significant tax benefits during retirement. Learn more in our post 4 ways a Qualified Charitable Distribution can reduce your taxes.
We’ve covered a wide range of topics in the retirement planning process. Planning out your retirement income sources, future tax liabilities, and Medicare costs is never-ending. Planning ahead will allow you to keep more of your hard-earned savings in your own pocket.
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