Required minimum distributions are many a retiree’s bugaboo. RMDs force retirees to withdraw a certain amount of money from their tax-deferred retirement savings accounts, whether they need that much money or not, often generating high income taxes for the year. Luckily, there are a few ways to minimize your RMDs — or even get around them entirely.
How RMDs work
Tax-deferred retirement savings accounts, such as traditional IRAs, allow you to contribute money tax-free, but they require you to pay taxes on the money you take out of the account. Without RMDs, a retiree could just leave the money in the account forever, and then their beneficiary could continue to hold the funds until their own retirement came around, resulting in enormous tax-free growth on the account’s investments. But the IRS doesn’t want you to get that much of a tax benefit, so starting at age 70-1/2, retirees must take distributions from their 401(k)s and traditional IRAs based on the IRS’ actuarial tables.
Qualified charitable distribution
If you plan to give money to charity anyway, why not do it in a way that will cut your tax bill? A qualified charitable distribution is a transfer of funds from your IRA directly to a qualified charity (which would be any charity that qualifies for the charitable deduction). You can transfer up to $100,000 per year in this fashion. Qualified charitable distributions count toward your RMD limit for the year, but because the money is going to a charity, you don’t have to pay income taxes on it. This is an excellent option for retirees who don’t need as much money as the RMD requires them to take; they can donate the amount they don’t need and avoid the extra income taxes on that money.
Qualified longevity annuity contract (QLAC)
Annuities can be an excellent financial tool for many retirees. An annuity ensures that you won’t run out of money, because the payments keep coming for as long as you live. A deferred annuity, in which you give your money to the insurance company but don’t start getting payments until a predetermined date, can make your payment stretch a lot further: The longer you wait to start getting payments, the bigger those payments will be relative to your investment.
If you use IRA funds to buy a deferred annuity, they will still be factored into your RMD calculation, even though the money will be locked up by the insurance company. In other words, your RMD won’t drop despite the fact that you’ve reduced the amount of money in the account.
The QLAC rules were designed to get around this catch-22. In brief, up to 25% of your IRA balance can be locked up in an annuity, and the proposed annuity payments will count toward your RMD for the year — even if the payments haven’t started coming yet.
The danger of a QLAC is that if you choose a long deferral period, you might not live long enough to break even on your investment. You’ll also lose out on the gains that money could have earned if left invested in your IRA. A QLAC can still make sense as a source of guaranteed income, but be sure to crunch the numbers carefully to confirm you’re getting a good deal.
Having a large chunk of your money in a Roth IRA, rather than a traditional IRA, can save you a bundle on RMDs. When you calculate your RMD for the year, you only need to consider the money in tax-deferred accounts and employer-sponsored accounts such as 401(k)s; anything in a Roth IRA doesn’t count. Thus, if your retirement savings are split 50-50 between traditional and Roth IRAs, your RMDs will be half the size they’d be if you had all of your money in a traditional IRA.
If you don’t have a Roth IRA, it’s never too late to do a conversion and move some of your money to a Roth account. However, when you make such a conversion, you’ll be required to pay taxes on the money you’re rolling over to the Roth account, so before you commit, do the math and confirm that you can afford the resulting tax bill. If those taxes are excessive, you can always spread the conversion out over several years to reduce the tax costs for any given year. And if you manage to move all of your money into Roth accounts, you can say farewell to RMDs for good.