The Best Strategies for Your Required Minimum Distributions

What's the most tax-efficient way to take out your RMD?

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Required minimum distributions are a fact of life for many people once they reach the age of 72. You must take the full required distribution each year. The penalty for any untaken amount is steep (50%!).

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 fits your situation? Since all distributions are taxed as ordinary income, you may be wondering the best tax-efficient way to take out your RMD. Thankfully, you have options.

Short RMDs Introduction

If you have a tax-deferred retirement account such as a traditional IRA or a 401(k), the IRS requires you to take required minimum distributions (RMDs) starting at the age of 72. This was increased from age 70½ in 2020 as a result of the SECURE Act. Those who reached age 70½ prior to Jan. 1, 2020, must continue with their RMDs under the old rules.

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.

The SECURE Act also changed RMDs for IRAs inherited on or after Jan. 1, 2020. Most non-spousal beneficiaries must now take a full distribution of the account within 10 years of inheriting it. The old rules govern accounts inherited prior to Jan. 1, 2020, and the beneficiaries can continue to take their RMDs as before.

1. Roth Conversion

One major advantage of a Roth IRA is the fact it is not subject to RMD requirements. This offers two benefits. First, the account owner can withdraw money from a Roth IRA at a pace that fits their needs or not at all. And second, 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.

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 amount must be weighed against the future benefits. This involves some number crunching.

You need to make some assumptions about your future tax rates and the direction of taxes in general. Additionally, it's important that you have cash outside of the account being converted to pay the taxes on the conversion. Otherwise, this process becomes very expensive.

Since the RMD amount is determined each year, a Roth conversion this year reduces or may even eliminate the amount of future RMDs. With the current low tax rates (pending any potential changes), a Roth conversion may be more attractive now than in future years.

2. Donate to Charity

A qualified charitable distribution (QCD) works well for those who have charitable inclinations and who don't need some or all of the money from their RMD. The SECURE Act raised the age to commence RMDs to 72, but it did not raise the age for QCDs. The minimum age to make a QCD is still 70½.

You can donate each year up to $100,000 of your RMD to a qualified charitable organization. The amount of the RMD used as a QCD is not included in your income and is not taxed. But there is no charitable deduction like you get with a straight cash contribution or a donation of appreciated securities.

As mentioned, the QCD withdrawal is not counted as income to you. This keeps your income level down in case you need to qualify for Medicare coverage the following year. Additionally, the amount withdrawn from the IRA account for the QCD serves to reduce RMDs in future years.

One note of caution. QCDs involve some complex rules. The SECURE Act ended the prohibition against those aged 70½ or older from contributing to a traditional IRA account if they have earned income. But annual deductible IRA contributions made from age 70½ onwards reduce the amount that can be used for QCDs.

3. If You Work, Defer Your RMD

For those still working at age 72, 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. This restriction also applies to those who were age 70½ prior to January 1, 2020, and are required to continue their RMDs if they are still working.

RMDs are still required on any IRAs or other retirement accounts that you may own.

Or consider doing a reverse rollover from an IRA to your current employer's 401(k) plan if it's allowed. 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 use another defined contribution retirement plan from a prior employer that was then rolled over to the IRA.

The advantage of 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.

4. Defer Your First-Year RMD

One of the quirks in the rules is that your first-year RMD can be taken as late as April 1 of the calendar year following the year in which you reach age 72. For example, if you reach age 72 on Jan. 2, 2021, your first RMD is not due until April 1, 2022. The amount would still be based upon your ending balance as of Dec. 31, 2020.

This allows you to defer paying taxes on the RMD in 2021 if you defer the distribution. However, you must then take two distributions in 2022. It often makes sense to take the first distribution in the year in which you turn 72 to avoid having to take two distributions the second year and incurring a higher tax bill.

But in some cases, it makes sense to defer the first-year distribution. Especially if you think the first year will be a high tax year for you or the second year will be an unusually low tax year.

5. 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 if your RMD causes you to withdraw a greater percentage of your nest egg than may be prudent.

You can't reinvest this money back into an IRA, but there is no reason you can't use the remaining dollars after taxes to invest on a taxable basis. The right move here depends upon your individual situation.

Roger Wohlner

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments. Roger contributes to his own popular finance blog, The Chicago Financial Planner, where he writes about issues concerning financial planning, investments and retirement plans. His work has been featured on Investopedia, Go Banking Rates, US News & World Report, Yahoo! Finance, Equifax Finance Blog and other publications. You can follow Roger on: Twitter - LinkedIn

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