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It’s smart to use tax-privileged investment accounts to save for retirement. By investing money in a traditional 401 (k) or individual retirement account, you can put off paying taxes on your retirement funds for what feels like an eternity.
But procrastination doesn’t mean you can avoid it forever; Uncle Sam finally gets his share. Annuity investors fortunate enough to have saved a nest egg in an IRA or 401 (k) will be billed in the form of Minimum Dividend Payouts (RMDs) beginning at age 72.
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What are RMDs?
RMDs are mandatory withdrawals that you must make from your Traditional Individual Retirement Account (IRA) or Traditional or Roth 401 (k). The exact amount you need to withdraw will depend on your retirement account balance and life expectancy, which we will discuss below.
Since any withdrawal made with money that has not yet been taxed (i.e. everything in a traditional retirement account) will generally be taxable upon withdrawal, RMDs are used to ensure that you ultimately tax your retirement funds. Otherwise, you could leave your money where it is so it can continue to multiply while avoiding higher income taxes.
Because of this, “RMDs are probably one of the biggest grumble I hear from customers,” said Desmond Henry, a Certified Financial Planner (CFP) in Topeka, Kan. “They don’t need or want the money from their IRAs, so they feel punished by them.”
But whether you like them or not, no later than April 1st of the year after your 72nd birthday.
How to calculate RMDs
Generally, RMDs are calculated taking into account your life expectancy and all of your retirement account balance subject to RMDs (also known as essentially all funds not held in a Roth IRA).
Depending on your marital status and the age difference between you and your spouse, you will need to find out what life expectancy factor applies to you using one of the three tables available from the IRS. You then take that number and divide your RMD Eligible Balance by it.
Here is an example: someone who is 75 years old gets a life expectancy factor of 22.9 according to the Uniform Lifetime Table. (This is the guide most people whose spouses are no more than 10 years younger than they are use to calculate RMDs.) So a 75-year-old with $ 200,000 in an IRA should have this year claim a distribution of $ 8,734. That’s about 1/23 of their savings.
An 80-year-old with $ 200,000, meanwhile, has a payout period of 17.9, which means he would need to withdraw $ 11,173 – a higher amount because theoretically he has fewer years to zero that balance for tax purposes .
What’s the best way to take RMDs?
How best to take RMDs will depend on your individual circumstances, but there are two things to keep in mind here. You may want to keep the money in your retirement account until December 31st of a specific tax year in order to maximize the return on your investment.
Alternatively, you may prefer to take your RMD in equal parts throughout the year – 12 monthly payouts, for example – to avoid market timing and ensure a consistent retirement salary for yourself. That’s basically an inverted dollar cost average.
While you and your financial advisor can run the numbers out to determine the most convenient time to make your withdrawal, the best way to get an RMD ultimately depends on what works best for you. However, you should make sure you withdraw at least the minimum by the end of the year because …
There is a heavy penalty for incorrect RMDs
Never skip an annual RMD. For this, the IRS imposes a huge penalty: 50% of the amount that should be withdrawn. If you should have taken $ 9,500 and you didn’t, the IRS will levy an excise tax of $ 4,750, far more than the income tax bill would have been.
And no, you will not be able to make up for missing withdrawals in the years to come or have previous excessive withdrawals credited. The RMD must be taken in that tax year.
Can you avoid RMDs – or at least relieve the pain?
To answer briefly, no and then yes. The invoice for the tax relief for all tax-privileged retirement accounts is finally due. There is really no way around it. But there are countless ways to tinker with the allegations. Here are just a few:
Donate to charity with a QCD
Once you’ve calculated your RMD, you can donate up to $ 100,000 to an IRS-authorized charity of your choice through a Qualified Charity Distribution (QCD). Why give it away? The RMD won’t add a cent to your tax bill and you’re doing good in the world.
But be careful: if you accept the distribution yourself and donate later, you may still have to pay taxes. A direct distribution from account to charity is superior for tax reasons.
Use the work in progress exception
Workers who do not retire by age 72 are exempt from RMDs … but the exemption only applies to the money saved in their current employer’s plan. Those approaching the age of 72 and considering this strategy should consolidate their retirement funds into their current work plan.
Delay RMDs with a QLAC
Using funds from a traditional IRA or traditional 401 (k) to purchase a Qualifying Longevity Annuity (QLAC) contract can potentially reduce your RMDs.
A QLAC is a form of deferred annuity and you can defer the payment of QLAC annuities until you are 85 years old, which will defer the tax bill for some of your retirement funds for an additional decade or more beyond the age of 72. It’s not a permanent solution. but it keeps some of your savings away from RMDs and the tax officer for a while.
Avoid RMDs with a Roth conversion
Roth IRAs are the only tax-privileged retirement account that does not have RMDs. (Even Roth 401 (k) s need to be transferred to Roth IRAs to avoid RMDs.)
After you retire, but before the RMD due date reaches the age of 72, you have a potential window of opportunity to take advantage of a Roth conversion, which is probably the most effective and underutilized strategy for dealing with RMDs . Here’s why:
Most people see their income drop immediately after they retire, which makes it a perfect time to convert a traditional IRA or 401 (k) to Roth IRAs while sitting in a lower income tax bracket.
“Of course, this strategy doesn’t come without warning,” said Henry. “First of all, you must be aware that you will have to pay tax on these funds when moving input tax funds from a retirement account to a Roth IRA.” Additionally, you need to be careful not to increase the portion of your Social Security benefits that is subject to federal income tax or triggering IRMMA, the Medicare surcharge tax.
As with any complicated financial maneuver, it is best to consult a financial advisor before embarking on this particular strategy.
Save your RMDs in a Roth IRA
Since most retirees will have to take RMDs at some point, consider keeping the cash you had to withdraw in a Roth IRA. This won’t help you avoid RMD-driven income taxes, but at least you’ll feel better knowing that money can then grow tax-free – and RMD-free – until you or your successors actually need the funds.
The final word on RMDs: plan ahead
When you start working, make a deal with Uncle Sam: To help you build your retirement savings faster, you can get tax break and avoid paying capital gains taxes that you would pay on a taxable investment account. However, customers often forget about that compromise, Henry said. “I like to remind you that Uncle Sam always gets his share; it’s just a matter of when, ”said Henry. “Fortunately, there are strategies to delay or even minimize the tax effects.”
If you can manage to ponder your retirement planning early in your career, forego the immediate tax breaks of a traditional IRA or regular 401 (k) and invest some of your money in a Roth IRA. These funds will never be subject to federal taxes or RMDs. And if for some reason you can’t use this strategy, consider one of the tactics above to minimize the potential pain of RMDs later in life.
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