Retirement plans offer a host of benefits, from lower taxes
to automated saving. But Uncle Sam makes you pay for these benefits,
eventually, by requiring you withdraw money from your account whether you need
it or not.
When you turn 72, required minimum distributions (RMDs)
begin for most tax-advantaged retirement plans. In year one, they usually
amount to around 3.6% of your account balance, then increase to an average of
about 6.5% of your balance. If you skip an RMD, you could be on the hook for an
Internal Revenue Service (IRS) penalty equal to 50% of that year’s RMD amount.
Most retirees make RMDs a key part of their retirement
paycheck, but if you’d prefer not to withdraw and spend your retirement funds,
you have a few options.
1. Skip RMDs with a Backdoor Roth IRA Conversion
There is one type of retirement plan that lacks RMDs: the
Roth individual retirement account. There are income thresholds that limit who
can contribute to a Roth IRA, but anyone can roll balances from other
retirement accounts into a Roth IRA.
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Rolling over retirement savings into a Roth IRA can help you
skip RMDs. As an added benefit, once you’ve completed a backdoor Roth
conversion, future withdrawals are completely free of income taxes, no matter
how much your balance grows.
There’s just one catch: Completing a Roth IRA conversion is
a taxable event. This means you’ll have to pay income taxes, based on your
current marginal tax rate, on any funds you roll into a Roth IRA. Most experts
would only encourage a Roth IRA conversion if you expect to pay high income
taxes in retirement than you do now.
Here’s a related strategy: If your income in retirement is
low enough, simply deposit each annual RMD amount into a Roth IRA after you
turn 72. Assuming you qualify to contribute a Roth IRA based on your earned
income, you can satisfy the RMD mandate while also positioning the money for
years or even decades of additional tax-free growth. Just keep in mind, you
need to wait five years from the time you convert each year’s RMD to access the
money free of early withdrawal penalties.
2. Keep Working to Avoid RMDs
If you keep working, you can delay taking RMDs from the
retirement account you have under your current employer-sponsored retirement
plan. Note that this only protects you from RMDs from your current employer’s
retirement plan. You’ll still have to take RMDs from any employer-sponsored
accounts you still have from prior jobs, and you can’t avoid RMDs from
traditional IRAs this way.
Keeping this option available is an argument in favor of
rolling over qualified retirement accounts, including traditional IRAs, into
your current employer-sponsored plan. If you plan ahead and roll all your
account balances into your current employer’s plan, you would make it possible
to avoid all RMDs by continuing to work.
Surprisingly, the IRS has not strictly defined what it means
to be “still working” when you’re age 72 or older. The general interpretation
appears to be that if the employer still considers an you employed, you can
avoid taking RMDs, even your work hours and responsibilities are limited. One
more thing: You must be employed throughout the entire year to qualify for the
exception to escape RMDs. But keep in mind that once you do stop working, you
are required to start taking distributions by April 1 of the following year.
3. Do You Have a Much Younger Spouse? You Could Lower
Your RMDs
Are you married? Are you at least 10 years older than your
spouse? If so, you may be able to reduce your RMDs by naming your spouse as the
sole beneficiary of your qualified retirement account or IRA.
Most people use the IRS Uniform Lifetime Table to calculate
their RMDs, but if your sole beneficiary is a spouse who is more than 10 years
younger than you are, you may use the Joint Life and Last Survivor Expectancy.
By factoring in your spouse’s longer life expectancy when calculating your RMD
amounts, you end up with a higher life expectancy factor—and therefore a
smaller RMD.
Take a 75-year-old woman with an IRA balance of $500,000
whose new husband is a 50-year-old man. After naming her younger spouse as the
sole beneficiary of the IRA, allowing her to utilize the joint life expectancy
table, she would have a life expectancy factor of 34.7. Her RMD would be
$14,409.22 ($500,000/34.7).
If she kept her younger husband away from her IRA, she’d
calculate her annual RMD via the uniform lifetime table, which would assign her
an expectancy factor of 22.9. In this case, her RMD would be $21,844.06. By
naming her much younger husband as the sole beneficiary, she’d reduce her RMD
requirement by over $7,000 that year.
4. Reduce RMDs with a Qualified Longevity Annuity
Contract (QLAC)
A qualified longevity annuity contract (QLAC) is a deferred
annuity contract designed to keep you from outliving your retirement savings.
You can fund a QLAC using money you’ve saved in your 401(k) or an IRA, and the
annuity starts paying you back at the year of your choosing before you turn
85—when you must begin taking payments. Any money you move into a QLAC is
excluded from RMD calculations.
The amount of retirement savings you can place in a QLAC is
limited. For the 2021, you can contribute up to 25% of your retirement asset
balance or $135,000, whichever is less. For example, if you have an IRA with a
balance of $160,000, you can elect to contribute $40,000 to your QLAC, thus
excluding $40,000 from your RMD.
It is important to also understand that while a QLAC may
allow you to lower your RMDs, there are downsides. You may have more or less
ability to change the year your QLAC payments begin, but by the age of 85 you
must begin taking payments. As an annuity, there is a possibility you will not
be able to use all the money if you pass away after starting payments.
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