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 you 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 72. 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 72. Keep in mind, 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 72, 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 72 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
Roth IRAs are fantastic. Besides the fact that all qualified withdrawals are tax-free, they do not have RMDs. You can leave the Roth IRA 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.
There is a strange Roth-account exception to this no-RMD rule! This is a perfect example of a rule that makes no sense. Even though RMDs are not required for Roth IRAs, RMDs are required for Roth 401ks, 403bs, and 457s. Thankfully this is very easy to fix. By merely rolling your Roth 401k, 403b, 457 into a Roth IRA, you’ll avoid the RMD requirements. That’s it – it’s probably the simplest tax saving you move you can make.
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.
One thing to keep in mind, in November 2020, the IRS announced the life expectancy tables for RMDs will be updated for the first time since 2003. The good news is that the IRS now expects you to live two years longer than they did in 2003. This will result in slightly lower RMDs beginning in 2022. We’ll use the current tables for all of the following examples and compare them to the new tables in 2022.
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 22. He divides $800,000 by 22 to get $36,363.64. That is the minimum amount John must withdraw from his 401k. When the new tables are in effect, his life expectancy divisor would be 23.7, and his RMD would be $33,755.27, a $2,608.37 reduction.
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 both you and your spouse’s ages.
For example, Mary, age 78, is married to Steve, age 67. Her IRA balance is $600,000 on December 31 of last year. According to the Joint Life Expectancy Table, the divisor is 21. By dividing the balance by 21, Mary’s RMD is $28,571.43. When the new tables are in effect, her life expectancy divisor would be 22, and her RMD would be $27,272.72, an almost $1,300 reduction.
There are several variables for RMDs, and most times, you won’t have to calculate your RMDs on your own. Typically, your advisor or the company holding your retirement account will do the calculation 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
The penalty for not taking RMDs is severe. If you don’t withdraw your full RMD by December 31 (or April 1, in the year of your first RMD), you’ll be subject to a 50% tax on the amount that wasn’t distributed.
If your annual RMD was $40,000 but only took out $20,000, you would be charged a 50% penalty on the $20,000 difference and would owe a $10,000 penalty! And that’s in addition to your regular income tax due.
There is an escape hatch. If you file Form 5329 – Additional Taxes on Qualified Plans with the IRS when you file your taxes, the IRS generally waives penalties if you take your RMD and report it promptly. It is up to the IRS’s discretion, though, and is not guaranteed. Don’t play with fire, and don’t forget your RMD.
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
We talk about investment diversification, but you also need retirement account diversification. You can have too much of a good thing, and that applies to your retirement accounts as well. 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. They really come into play if you’re maxing everything out and have significant brokerage account savings – then it’s time to think about a low cost, variable, non-qualified annuity.
It is a balancing act between your current tax situation against your future projected retirement tax liabilities. Throw in tax laws that change every so often – it’s a continual game of cat and mouse.
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 do an analysis to make sure the benefits outweigh the cost to convert. 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 which 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 from 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 each year (well, other than the Social Security decision) based on your needs and tax laws. learn more in Reduce your retirement risk with an effective retirement distribution strategy before it’s too late.
Qualified Charitable Distribution (QCD)
If you don’t need RMDs for living expenses, you have a few options. You might move the RMD to a taxable investment account, although that doesn’t avoid the income tax due. Another option to consider 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 some significant tax benefits during your retirement years. 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 a never-ending exercise. Planning ahead will allow you to keep more of your hard-earned savings in your own pocket.
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