Summary/TL;DR
Required minimum distributions (RMDs) are mandatory distributions from pre-tax retirement accounts that begin between a taxpayer’s age 73-75, depending on their year of birth. In many instances, these distributions will cause taxable income to jump considerably, resulting in far more than is necessary to be paid in taxes. Working with a professional to create a tax plan that integrates strategies such as well-timed Roth conversions, QLACs, and qualified charitable distributions can potentially save you over six-figures in taxes throughout retirement.
Introduction
You’ve worked diligently your whole life and saved into your 401(k), just like you were told to. Now, it’s time to retire, and between your home being paid off and social security kicking-in, you find that the distributions you need from your portfolio to maintain your living standards are very modest in relation to how much it will earn between dividends, interest, and growth. By the time you pass away, you’ll leave a small fortune to your children, establishing a legacy that will far outlive your time on this earth.
If only life were so simple…
To your dismay, you’ll discover that, somewhere around your 75th birthday, you’ll be forced to distribute from your nest-egg and include every last dollar in your taxable income, thrusting you into a higher tax bracket and needlessly sending tens-of-thousands of dollars every year to the government.
These forced distributions, called required minimum distributions (RMDs) are the topic of today’s post. What they are, how they work, what accounts they apply to, and strategies for mitigating their potential harm will all be addressed below.
RMDs – A Tax Bomb Waiting To Happen
Required minimum distributions (RMDs) are forced distributions, mandated by the federal government, that you must begin taking from any pre-tax retirement accounts (401k, 403b, Traditional IRA, etc). Under current law, RMDs will begin somewhere between your age 73-75, depending on your birth year.
The exact way that RMDs are calculated aren’t a relevant detail. What you need to know is this: They are a percentage of your account (the larger your account balance, in other words, the more in dollars you will be forced to distribute) and generally begin around 4%. The older you are, the higher this percentage becomes.
With the exception of the first year that you’re required to take distributions, you have until the end of the calendar year to make them. You may take them in even monthly increments, all in one lump-sum, or at your own leisurely discretion. Furthermore, the IRS doesn’t care which account you take your distributions from as long as the total that’s required of you is met for the year. For example, suppose I have two Traditional IRAs, one that’s invested in liquid market investments and another that’s self-directed. Even though the self-directed IRA is likely invested in illiquid investments that I can’t easily access, it will still have an RMD for the year that I am required to satisfy. Fortunately, I can take this RMD from my other IRA (in addition to the RMD required of it). Finally, in the first year that RMDs are required, you have until April 1st (not the 15th!) of the following year to make your distributions.
Since RMDs are levied against pre-tax retirement accounts, every dollar that’s distributed will be included in your taxable income. There’s nothing you can do about this. Unless you’ve engaged in proper tax planning, your pre-tax retirement accounts are a tax-bomb waiting to detonate.
Here’s an example of how this might work in the real world. Let’s assume you’re 72 years old and are scheduled to begin RMDs next year. You and your spouse collect $60,000 in annual social security benefits and you’ve only had to make monthly before-tax distributions of $2,500 from your Traditional IRA to live comfortably up to this point. Currently, your tax return will look something like this:
Next year, however, you will have to begin RMDs. Your IRA has grown considerably since you’ve retired and currently sits at a balance of about $2,000,000, making your RMD at age 73 about $80,000, or $50,000 more than you need to live comfortably. Unless you do something to prepare, your tax return will look like this for the rest of your life:
Your $50,000 RMD resulted in an over $80,000 increase in taxable income (to understand how this is possible, visit this post), and over $10,000 in additional taxes owed!
And this is just the beginning. Assuming a modest 6% annual rate of return until your age 100, my financial planning software projects that you would pay almost $850,000 in taxes over the rest of your retirement, which is an average of over $30,000 annually!
Strategies For Minimizing The Tax Implications of RMDs
Now that we understand the potential problem, let’s discuss strategies for avoiding or minimizing the tax nightmare that RMDs can create.
Roth Conversions and Tax Diversification
Unlike their pre-tax counterparts, Roth accounts are not subject to RMDs. Strategically converting your pre-tax accounts to Roth in the years leading up to and throughout retirement is an exceptionally powerful strategy for minimizing the tax-impact of RMDs. One of my favorite strategies goes like this:
Contribute to your retirement accounts on a pre-tax basis and invest your tax savings into a brokerage account.
After retirement, convert your pre-tax savings into Roth and use your brokerage investments to pay taxes on the conversions.
Strategically distribute from your investment accounts to keep your taxable income at or below thresholds that minimize your tax liability, ideally keeping it at $0 or only a few hundred dollars every year.
You can read more about this and other tax diversification strategies in my posts here and here.
Qualified Lifetime Annuity Contracts (QLACs)
Qualified Lifetime Annuity Contracts (QLACs) are annuities that allow deferral of RMDs until your age 85. The amount that a taxpayer may invest in a QLAC is capped at $200,000 and is adjusted for inflation every year.
I’ve never recommended a QLAC for a client because, as an annuity, it is an inflexible solution. This doesn’t mean that there aren’t circumstances which render them appropriate, but I prefer other solutions 99% of the time.
Qualified Charitable Distributions
Qualified Charitable Distributions (QCDs) are distributions made from a pre-tax retirement account directly to a qualified charity. As long as you’re over 70½, the distribution will not be included in your taxable income and can be used to satisfy your RMD!
The Bottom Line – Get Help!
It’s almost never too late to plan for RMDs, even if you’re in the middle of taking them! This is an area where a proactive financial planner can make a considerable difference by potentially saving you (and your heirs) hundreds of thousands of dollars in taxes.
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