We spend decades putting money into our retirement accounts, then the moment finally arrives to start pulling it back out. Only it isn’t entirely up to us to choose when that moment is upon us—or how much to withdraw each year. IRS rules require that we begin making withdrawals from tax-deferred retirement accounts such as 401(k)s and traditional IRAs by the year in which we turn 70½. Failure to make these required withdrawals triggers extremely steep penalties—50% of the amount that we were supposed to withdraw.
These mandated withdrawals, officially called required minimum distributions (RMDs), sometimes cause complications, forcing us to liquidate investments that we would rather leave undisturbed…putting an end to tax-deferred appreciation for whatever amounts we withdraw…and potentially triggering hefty tax bills.
Here are seven ways to minimize the impact that RMDs have on your retirement savings…
- Take RMDs late in the year. IRS rules don’t specify when during the year you must take RMDs. If you don’t need the money right away, it usually is best to wait until late in the year to get every possible month of tax-deferred growth.
There is one potential downside to such a delay, however—if you pass away or develop a serious health issue that prevents you from handling your financial affairs before making the withdrawal, your spouse or heirs will have to do it for you. The IRS doesn’t accept death or disability as an excuse. Give your spouse and/or heirs specific instructions about how to make RMDs on your behalf if necessary, and include a durable power of attorney in your estate plan to ensure that they can.
Warning: The IRS offers a special grace period in the first year that you are required to make withdrawals—for this first year only, you can make RMDs as late as April 1 of the following year without penalty. But it usually does not pay to take advantage of this grace period.
If you postpone making your initial RMD until the following year, you also will have to make your second annual RMD during the same calendar year.
Because the amounts withdrawn count as income, that double withdrawal could push you into a higher income tax bracket and/or make a higher percentage of your Social Security benefits taxable.
What to do: Postpone your initial withdrawal past December 31 only if your income—and resulting tax bracket—happen to be exceptionally high in that first year. Discuss this possibility with your tax preparer and/or financial planner before year-end if you believe it might apply to you.
- Do a Roth rollover to reduce or eliminate future withdrawal requirements. The IRS doesn’t require people to make withdrawals from their Roth IRAs and Roth 401(k)s (the only exception is that heirs are required to make withdrawals from an inherited Roth).
If you have money in a tax-deferred account that you do not need for your retirement and intend to leave to your heirs, rolling it over to a Roth could be a smart strategy—if you can afford to pay the income taxes triggered by such a rollover without dipping into your tax-deferred savings.
In addition to the RMD advantage, Roth accounts allow your money to grow without facing additional taxes. The math behind Roth rollovers can get complex, however, so discuss this with a financial planner first.
- Consider withdrawing more than the required amount in years when you fall into an unusually low tax bracket. Estimate your taxes before each year ends. For these purposes, don’t sweat the details—just try to get a general idea of what your adjusted gross income will be.
If you discover that your income will be short of the point where Social Security benefits start to become taxable—currently $25,000 for single filers, $32,000 if married filing jointly—it’s probably worth withdrawing as much additional money from your tax-deferred accounts as possible without going over these income levels.
It even might be worth increasing your withdrawals—or doing a Roth conversion—until your income approaches the top of the 15% tax bracket, if you usually fall into a higher bracket. In 2013, the top of the 15% tax bracket is $36,250 for single filers…$72,500 for married people filing jointly.
Here’s the reasoning: You or your heirs eventually are going to have to pay income taxes when you take money out of your tax-deferred accounts, so you might as well do so in years when your tax rates are as low as possible. (Excess withdrawals made in one year cannot be applied to the following year’s withdrawal requirement, however.) If you don’t need the additional money that you withdraw, consider reinvesting it in a taxable investment account.
- Withdraw money from the tax-deferred investments that seem least promising. You get to choose which investments to liquidate within a tax-deferred account each year—you don’t have to pull money out of every investment. In fact, if your tax-deferred accounts are traditional IRAs, you don’t even have to withdraw money from each of your IRAs each year, as long as the overall amount that you withdraw from all of your traditional IRAs meets or exceeds withdrawal requirements. Instead, sell off the investments that seem likely to earn the lowest returns in the coming year or two. For example, you might want to scale back on long-term bond investments, especially since rising interest rates are expected to hurt the performance of such bonds in coming years.
Warning: If you have tax-deferred savings in “qualified-plan accounts,” such as 401(k)s, inherited IRAs or Keogh accounts, you must withdraw at least the minimum required percentage from each separate account each year.
- Speak with your tax adviser before withdrawing highly appreciated company stock from a 401(k). Special tax rules might allow you to pay income tax only on the cost basis of these shares—the amount that you originally paid for them—rather than their current value.
You also would pay long-term capital gains tax on the “net unrealized appreciation” of the shares—but that rate could be much lower than your income tax rate. The tax savings from this can be substantial, but the rules are complex. Speak with a tax professional if the rules might apply to you.
- Consider rolling your IRAs and/or your 401(k)s from prior employers into your current employer’s 401(k) if you work past age 70½. You are not required to take distributions from your current employer’s 401(k) while you still are working (unless you own 5% or more of the company).
You are required to take them from your non-Roth IRAs and previous 401(k) accounts, however. That can lead to hefty tax bills on your withdrawals if the income from your job pushes you into a high tax bracket.
Ask your current employer’s benefits department if it allows rollovers into its 401(k). If so, rolling other tax-deferred retirement savings into this account will shield them from RMDs as long as you continue to work.
Warning: Use this strategy only if your current employer offers attractive investment options and charges reasonable fees within its 401(k).
- For the 2013 tax year, consider making charitable contributions to satisfy withdrawal requirements. You could have part or all of your RMD sent directly to a qualified charity if neither you nor your heirs need the money.Such a withdrawal will not trigger income tax or affect the taxability of your Social Security benefits. (These charitable distributions are capped at $100,000 per taxpayer per year.)
Urgent: This option is set to expire after the 2013 tax year, although legislators may extend it.
How Much Must You Withdraw?
Your age and the amount you had saved in tax-deferred retirement plans at the end of the prior year typically determine how much you must withdraw from your tax-deferred accounts each year, starting in the year that you turn 70½.
There is an exception: If the primary beneficiary of your tax-deferred retirement account(s) is your spouse and he/she is more than 10 years younger than you are, that will lower your withdrawal requirements.
The Financial Industry Regulatory Authority (Finra) offers a calculator that can help you determine the amount you must withdraw each year (apps.finra.org/Calcs/1/RMD).