Simply cashing the check and calling it a day could end up costing you money in the long run.
Just because you’re done saving and growing your money for retirement doesn’t mean you have to stop thinking strategically about it. Indeed, you should make a point of continuing to think. Although your allocation may look different than it did in the past, how you move and manage these assets in retirement arguably matters even more in retirement than it did while you were working.
To this end, here’s a rundown of four simple strategies for minimizing the tax bills created by required minimum distributions — or RMDs — from your IRA accounts once you can no longer postpone them.
What’s a required minimum distribution?
Just as the name suggests, required minimum distributions are a minimum amount of money that must be withdrawn from a traditional IRA, rollover IRA, or 401(k) account once you turn 73 years old (although this figure is being bumped up to 75 in 2033).
The amount is a percentage of the account’s value that changes with your age. For instance, 73-year-olds must remove nearly 4% of their account’s value at the end of the previous year, but anyone 83 years old this year is required to take out almost 6% of their IRA’s year-end balance. The IRS’s math ultimately intends for these accounts to be finally emptied out in the same year their owner passes away, although this rarely actually happens. Most people end up outliving at least some of their savings.
These distributions are also almost always taxable income since your contributions to IRAs are almost always tax-deductible when they were deposited into the account.
This of course is the reason you want to think strategically about RMDs, minimizing taxation’s net impact as much as possible. With that goal in mind, consider these four following tactics.
1. Start withdrawing when you turn 59½
Although you’re required to start taking required minimum distributions at the age of 73, you’re not required to wait until then. You can begin removing money from individual retirement accounts — without penalty — once you turn 59½.
This is generally discouraged, and for good reason. Chief among these reasons is the obvious fact that once these funds are no longer in an IRA, money that was intended to be saved and grown can now be easily squandered. These are also taxable withdrawals, adding to an individual’s income tax bill at a time when their earnings are likely strongest, resulting in their biggest tax bills.
For disciplined people who can see and sense the future, however, there’s a case to be made for this seemingly unusual decision. That is, you’re shrinking the size of your IRA now, so your future RMDs will be smaller. If you have reason to believe you’ll actually be receiving more taxable income in the future than you are now, it makes sense to go ahead and push your current income up to the brink of your next-higher tax bracket.
Of course, this strategy is only smart if you invest any withdrawn money into something that will continue growing (even if that growth is taxable).
2. Take in-kind distributions
You don’t even have to cash out a position to take this withdrawal, either. Although that’s what plenty of people end up doing, you’ve also got the option of taking in-kind distributions of stocks, funds, or bonds from an IRA and placing these holdings into an ordinary brokerage account.
Image source: Getty Images.
This won’t sidestep a tax bill. You’ll still owe taxes on the fair market value of the assets in question at the time the transfer is made, which — if applicable — may or may not satisfy any RMD.
These transfers can be made while the asset is priced at a level of your choosing, however, without forcing you to go through the hassle of selling it only to reinvest this cash at a later time. With a bit of savvy timing you can better control any tax liability without wrecking your portfolio’s allocation — even for just a day.
3. If working, move your account to your employer’s plan
Required minimum distribution rules apply to traditional IRAs, including money you’ve rolled over into a traditional IRA. They also apply to most 401(k) accounts and other workplace-offered retirement savings plans if a former employer allows its workers to leave their accounts in place once they’re no longer working. If you’re still working and actively contributing to your current employer-sponsored plan, however (and unless you own 5% or more of the company), RMD rules don’t apply to this money.
Here’s the strategic aspect of this rule: While not all employers allow it, in some cases, money from most other types of personal retirement accounts can be transferred into a 401(k). For as long as you remain employed and participate in this workplace-sponsored plan, these so-called “reverse rollovers” will make these funds exempt from RMD rules that would otherwise apply.
It’s not a move to take lightly. Unlike traditional IRAs, barring certain hardship and loan exceptions, this money is effectively untouchable until you officially retire and stop contributing. You’ll also likely have access to fewer investment options. Only tax-deductible contributions (and their resulting growth) are eligible for transfer to a similarly tax-deferring retirement account, too, so you’ll need to have kept meticulous records for the IRAs you’d like to move to your employer’s 401(k) plan.
If you’ve got good reason to postpone your RMD and don’t mind continuing to work, though, it’s an option.
4. Convert to a Roth and pay any taxes out-of-pocket
Finally, if you’d simply like to remove any worry about future required minimum distributions altogether, in most cases you can convert your current IRA to a Roth IRA, which doesn’t require distributions — ever.
Don’t misunderstand. You will be paying taxes on this money. You’ll just be doing it all upfront. The conversion to a Roth is typically a 100% taxable event in and of itself. Once these funds are within a Roth though, you can do whatever you like with them without having to take RMDs.
It sounds like a wash, and in many ways it is. As was noted, you’re just paying taxes in one fell swoop rather than as you take future distributions. You’re still handing money over to the IRS. However, going forward, any further gains inside the Roth will be tax-free.
There are other arguments to be made for using this strategy as well. Chief among them is the opportunity to make the conversion while the market’s down, minimizing the tax bill due that year. If you happen to have the extra cash lying around, there’s also no requirement that any resulting taxes need to be paid with cash removed from the retirement account itself. You pay the taxes on Roth conversions along with your usual income tax. If you’ve got the money in a checking or savings account, that’ll work.
