For those with tax-deferred retirement accounts such as a traditional IRA or a 401(k), age 70½ is the time when required minimum distributions (RMDs) generally commence.
RMDs are calculated annually based on the balance in the account(s) as of the prior Dec. 31. These distributions are fully taxable and represent a way for the government to “get their money back” for having allowed you to contribute on a pre-tax basis and for the ability for this money to grow on a tax-deferred basis. All distributions are taxed as ordinary income; the preferential capital gains rates do not apply.
Additionally, in certain cases, the beneficiaries of inherited IRAs will also be subject to the RMD requirement as well.
Here are some strategies to consider surrounding your RMDs.
One major advantage of a Roth IRA is the fact they are not subject to RMD requirements. This offers two benefits: The account owner can withdraw at a pace that fits their needs or not at all, and the Roth is a great estate planning tool. Spousal beneficiaries can treat the Roth IRA as their own, and the account is not subject to RMDs during their lifetime.
Additionally, while RMDs or a full withdrawal over a five-year period are required for non-spouse beneficiaries, these withdrawals are not taxable.
Even with these advantages, the decision to convert some or all of your traditional IRA money to a Roth is a complex one. The amount converted in a given year is taxable and the tax hit needs to be weighed against the future benefits. This involves some number crunching and making some assumptions about your future tax rates and the direction of taxes in general.
If the numbers make sense, a Roth conversion can reduce or eliminate the amount of future RMDs.
Qualified Charitable Distribution (QCD)
Congress finally made this provision a permanent option in 2015, allowing for more certainty in your planning.
The QCD is a viable strategy for those who have charitable inclinations and who don’t need some or all of the money from their RMD.
You can take up to $100,000 of your RMD and contribute that to a qualified charitable organization. The amount of the RMD used as a QCD is not included in your income and is not taxed. There is no charitable deduction as there would be for a straight cash contribution or a donation of appreciated securities for example.
The advantage is less taxable income. This may also help those whose income would otherwise result in higher than the base level costs for Medicare coverage the following year.
Those Working at Age 70½
For those working at age 70½, you may be able to defer RMDs on the 401(k) of your employer. In order to do this, you cannot be an owner of 5% or more of the company and your employer must have made the election in their plan document that allows for this option.
In conjunction with this option, you might consider doing a reverse rollover from an IRA to your current employer’s plan if allowed by the plan. This allows you to move money that was originally contributed on a pre-tax basis to your current employer’s plan. The source of the money can be pre-tax IRA contributions or pre-tax contributions made to a 401(k) or another defined contribution retirement plan from a prior employer that was then rolled over to the IRA.
The advantage to doing this is this money will then not be subject to RMDs while you are working for this employer.
The decision on a reverse rollover should take into account the quality of your current employer’s 401(k) plan including the plan’s expenses and the quality of the investment menu.
One of the quirks in the rules says the first year’s RMD can be taken as late as April 1 of the calendar year following the year in which you reached age 70½. For example, if you reached age 70½ on Jan. 2, 2016, your first RMD would not be due until April 1, 2017. The amount would still be based upon your ending balance as of Dec. 31, 2015.
This allows you to defer paying taxes on the RMD in 2016 if you defer the distribution. However, you will then have to take two distributions in 2017, using this example. It often makes sense just to take the first distribution in the year in which you turn 70½ to avoid having to take two distributions that second year.
In some cases, it may make sense to defer the first year distribution, especially if you think the first year will be a high tax year for you, or conversely the second year will be an unusually low tax year.
By this we mean use the RMD as a tool in managing your IRA account and your overall portfolio. If you need to sell holdings in the IRA to raise cash for the RMD, do this with an eye toward your overall asset allocation and the need to rebalance your portfolio.
For example, if you are overweight in stocks, sell off some or all of a stock-based holding(s) such as mutual funds, ETFs or an individual stock.
If you have multiple accounts including those that are taxable, take a total portfolio approach here and incorporate the RMD into any other moves you may be making.
Reinvest the RMD
While the RMD must be taken and taxes paid, this doesn’t mean you are obligated to spend this money. This is a critical issue for those of you whose RMD might cause you to withdraw a greater percentage of your nest egg than may be prudent.
You can’t reinvest this money back into an IRA, for example, but there is no reason you can’t use the remaining dollars after taxes to invest on a taxable basis. The right move here will depend upon your individual situation.
Required minimum distributions are a fact of life for many of you once you reach age 70½. It is important these distributions be taken to the full extent required; the penalty for any untaken amount is quite steep.
That said, there are several strategies to keep in mind regarding the RMD. To the extent the rules allow, why not make the RMD work in a way that meets your situation?