Many of our readers are planning to retire, and they want to know about required minimum distributions (RMDs). If you have a tax-deferred vehicle, RMDs are something that you should learn more about.
Tax-deferred vehicles are:
- IRAs (traditional)
When you’ve deferred taxes, you’re making an agreement with the IRS that you’re not going to pay taxes on this money now. But in the future, when you’re able to access the funds, the IRS will come knocking on your door because they want their cut of the money.
Under today’s requirements, you must start taking your required minimum distributions at age 72 – it was 70 and a half not too long ago.
RMDs are not a bad thing, and these are retirement accounts that you’ve been paying into for 30 or 40 years. However, since you’ll have to pay taxes on the distributions, some people get concerned.
Don’t be. This is money you saved and will be using for your retirement.
Understanding When You Must Take RMDs
RMDs are part of your retirement planning, and while you start taking them at age 72, this definition is a bit misleading. According to the IRS, you must begin taking distributions in the year you turn 72.
If you don’t turn 72 until December 31, guess what? You can take distributions from January 1st (you’re still 71) since it’s in the year that you turn 72, or you can wait until December. So, you can strategize to some degree on when is best for you to take your RMDs.
You must take the distribution by the calendar year end (with one exception listed below).
How RMDs are Calculated
The IRS will try and estimate your life expectancy, based on several factors, and then calculate your RMD. The required distribution can vary from year to year, so the RMD isn’t a fixed rate.
For example, let’s say that you have $500,000 in all of your IRA accounts.
If you have this much in your account on December 31st of the previous year, you would divide this amount by a factor that the IRS has created. The factor, at the time of writing this, is 25.6 for someone that is age 72.
The IRS figures that at age 72, you still have 25.6 years left to live. Your health isn’t personally calculated as these factors are across the board for everyone. So, you’ll be required to take the following RMD:
- $19,531.25 ($500,000 / 25.6)
You can take a larger distribution if you want. However, you must take the minimum amount and it’s added to your income for the year.
In your first year, you can defer the distribution until April. You may want to defer the distribution to avoid taxes, but you’ll still need to take the distribution the second year.
In fact, if you defer the first distribution, you’ll be required to take the first and second distribution in the second year, adding significantly to your yearly income.
What to Do If You Have Multiple Tax-deferred Accounts
If you have 5 different tax-deferred accounts that require RMDs, you can take money from one or all of them. The IRS doesn’t care which accounts the distribution comes from. However, they do care that you’re taking the RMD (based on the combined value of all accounts) and paying tax on it.
What Happens If You Miss an RMD?
You’re penalized. You can be penalized by as much as 50% for missing your RMD.
3 RMD Strategies If You Need to Take RMDs in the Near Future
For anyone that is not retired yet but will be in the near future and has these tax-deferred accounts, there are a few strategies that can help you:
1. Roth Conversions
If you have an RMD, you cannot convert it into a Roth account. However, what you can do is a Roth conversion before you hit age 72. If you convert today, there are no RMDs, but you do pay taxes today.
You’re still paying taxes, but you know today’s taxes and not what your tax burden may be in 10 years.
When you use this strategy, you’re controlling your tax burden because you decide to convert the account at a time of your choosing and at a favorable tax bracket. For example, if your Roth account grows at 7.2% per year, you’ll double your money in 10 years and won’t have to pay taxes on your RMDs.
Of course, this doesn’t make sense for everyone.
We run simulations to see if this is a good strategy for our clients.
2. RMDs are Required, But You Don’t Have to Spend the Money
Many times, we’ll advise people to take money out of the IRA and then put it in another investment account. You don’t have to spend the money that you take out of your account, but you do need to pay your taxes on it.
3. Qualified Charitable Distribution
We have many people who don’t need the entirety of their RMD, so they’ll leverage what is known as a qualified charitable distribution, or QCD for short. A QCD allows those who want to donate to charity to do so with tax benefits.
Let’s assume that you have a $20,000 RMD and want to donate $5,000, you can.
When you do this, you’ll pay taxes on $15,000 instead of $20,000. You will need to go through your IRA to make this distribution, but you need to ensure that the distribution is in the charity’s name, address, and Tax ID.
You want the custodian to do the transfer for you so that the money never enters your account.
If you’re planning on giving to charity any way, the option of making a qualified charitable distribution makes a lot of sense for anyone that has an RMD that they must take.
The earlier you plan to reduce your RMD tax burden, the better. But, even if you plan on using our last strategy to lower your taxes, you want to start as early as possible to make sure it gets done in time for tax season.