One of the most common questions I get from readers is,“When should I start thinking about required minimum distributions?” Myresponse often is, “as soon as you start investing.”
As a primer, annual required minimum distributions (RMDs)are mandated for traditional, tax-deferred accounts such as IRAs and 401(k)employer-sponsored plans starting the year you reach age 70½. Although you mayenjoy the benefit of tax-advantaged compounding and tax-deductiblecontributions, the reality is, these savings will be taxed when you withdrawthem. While it may not seem instinctive to worry about RMDs before you’rerequired to take them, the investing decisions you make today can impact youroptions for taking tax-efficient distributions in retirement and planning for bequests.Here are some practical guidelines for thinking about RMDs in advance—no matterhow old you are.
Age70½ and beyond: The RMD “reality show”
At this point, your options are limited as you’re subjectto distributions. But there are still some things you can do to ease the taxbite caused by additional taxable income.
If you’re charitably inclined, your first course of actioncan be to make full use of a qualifiedcharitable distribution (QCD). With a QCD, you can distribute up to$100,000 from your IRA to a qualified charity once you turn age 70½. The addedbonus with this type of distribution is that the QCD isn’t subject to federalincome taxes—in other words, the amount is excluded from your adjusted gross income.(Note that this amount can’t also be deducted as a charitable gift.) Keep inmind, the QCD option is available to every account owner. For married couples,this means the spouses can each make an annual QCD after they reach age 70½.
Take the RMD while rebalancing.This will help maintain the risk profile of your portfolio.
If you’re lucky enough not to need your RMD for spending,consider:
Reinvesting the net proceeds in a nonretirement account,being mindful of selecting tax-efficient investments such as broad-market indexfunds or municipal bond funds.
Converting to a Roth IRA after you satisfy yourRMD. While RMDs aren’t eligible for rollover or conversion to another IRA, theIRS has no issue with you taking more from the IRA than required.
If you’re in a low marginal income tax bracket, you cantake advantage of your low tax rate by withdrawing your RMD and doinga partial conversion. (Keep in mind, both your RMD and the amount you convertwill be taxable, which will accelerate your income.) Converting sometraditional assets to Roth provides you with tax diversification, which cangive you more flexibility when spending in retirement. It also reduces yourtraditional IRA balance, which will be subject to future RMDs.
If you’re making a QCD, you may choose to do a partialconversion (which increases your income) in addition to taking a QCD (whichisn’t reported as income). You’ll satisfy your RMD, your QCD won’t be subjectto income tax, and you’ll get the extra benefit of tax diversification.
You have a onetime option to defer the RMD for the year youturn 70½ until April 1 of the following year. While this seems compelling, keepin mind, you’ll then need to take 2 RMDs during the following year. Taking 2RMDs could push you into a higher marginal tax bracket, causing you to payhigher taxes on the extra income.
Ages60–70: The RMD “acceleration decade”
I refer to this stage as the RMD planning “sweet spot”because with careful planning, there are strategies that can help you set thestage now for lower RMDs in the future.
If you’re still working, make sure you maximize yourcontributions to tax-advantaged accounts. You most likely have larger balancesin traditional, tax-deferred accounts, so before you add more to thoseaccounts, consider diverting additional savings to a Roth option to build taxdiversification. While you won’t benefit from tax deductions on thecontributions, withdrawals from the Roth account will be tax-free. And RothIRAs aren’t subject to RMDs in retirement.
If you’re retired (or winding down to retirement!), theseyears may provide prime planning opportunities to build tax diversification andlower future RMDs.
Consider your options with claiming SocialSecurity benefits. One strategy could be to spend from yourtax-deferred assets between retirement and age 70 while deferring SocialSecurity. This will increase your Social Security benefits and reduce futureRMDs.
Another option is to consider Rothconversions.* Though the amount you convert will be subject toincome taxes, you may be in a lower tax bracket, especially if you’re deferringSocial Security to age 70. Be very careful with how much you convert as it maynot only push you into a higher marginal tax bracket in the year of conversion,but could also impact other things including taxation of Social Security (forthose receiving benefits) and Medicare Part B premiums (which are based onincome thresholds). Roth distributions, on the other hand, don’t negativelyimpact the taxation of Social Security or increase Medicare Part Bpremiums … so you may be incurring some “short-term pain for long-term gain.”
If you have a Roth 401(k), consider rolling it over into aRoth IRA to avoid having to take unnecessaryRMDs.
Underage 60: The “tax-diversification trifecta”
For those of you in this broad stage, the focus should beto make full use of tax-advantaged accounts. As accumulators, you can bethoughtful about investing in 3 distinct types of accounts: tax-deferred, Roth,and taxable nonretirement accounts. These accounts have different taxstructures, which can help you distribute the burden of taxes throughout yourinvesting life. You can also explore other account types such as heath savingsaccounts, which offer different financial benefits.
I introduce these strategies as guidelines for you toconsider. Let them serve as starting points as you make decisions aboutinvesting in and withdrawing from your portfolio. At any age, you have manyoptions to help manage tax efficiency and you may want to consider partneringwith a financial planner to personalize your plan.
Special thanks to my colleague, Hank Lobel, for hiscontributions to this blog.
*Roth withdrawals are assumed to be in the following order:contributions, then conversions, and lastly earnings. Account owners underthe age of 59½ who withdraw conversion dollars and don’t meet the IRS-approvedexceptions will face a 10% penalty. There are no taxes on earnings as long asyou’ve held the account 5 years and you’re age 59½ or older, or a specialexception applies. Withdrawals from traditional IRAs are assumed a pro ratashare of pre-tax contributions, earnings, and post-tax contributions (yourbasis). Generally, if you make a withdrawal from a traditional IRA and you’reunder the age of 59½, you’ll be subject to income tax and a 10% penalty.
Click herefor the original blog article from Vanguard.