Required Minimum Distributions (RMDs): A Tax-Wise Approach for IRA Owners
Congratulations on successfully building your Individual Retirement Account (IRA) nest egg! As you enjoy the peace of mind that comes with financial security, it's important to be aware of an aspect of retirement planning that can sometimes be overlooked: Required Minimum Distributions (RMDs). These mandatory withdrawals can seem like an unwelcome intrusion, but we are here for you! In this guide, we will explain what RMDs are and why they matter, and, most importantly, we will provide you with strategic tips to minimize their impact on your hard-earned savings.
RMDs are IRS-mandated withdrawals that kick in when you reach the age of 72 (73 if you reach 72 after Dec. 31, 2022). They apply to traditional IRAs, SEP IRAs, SIMPLE IRAs, and other employer-sponsored retirement plans. The purpose? The IRS wants to ensure they get their share of the taxes on the money growing tax-deferred within your IRA.
Calculating Required Minimum Distributions (RMDs) for Individual Retirement Accounts (IRAs) involves a formula blending the account balance and life expectancy. The account balance is the cumulative result of contributions, gains, and losses over the years. Suppose your IRA balance at the required distribution age (typically 73 for traditional IRAs) is $500,000. In that case, your RMD is calculated by dividing this balance by your life expectancy, as determined by IRS tables. Please keep in mind that the life expectancy tables are different for non-spousal inherited IRA accounts and should be calculated differently. Suppose the life expectancy of a 73-year-old owner of a contributory IRA is 25 more years. Your RMD would be $20,000, added to your taxable income for the year. The calculation ensures you withdraw a portion of the IRA over your expected lifespan, paying the corresponding taxes.
The IRS's intention behind the Required Minimum Distribution (RMD) rules is not to deplete your entire Individual Retirement Account (IRA) but rather to ensure that a calculated portion is withdrawn and subjected to taxation over your life expectancy. It is also important to note that just because you are taking Required Minimum Distributions does not mean you have to spend them; you are just required to pay taxes on them.
RMDs sound straightforward, but remember the catch: they're generally treated as ordinary income, which means you'll be taxed at your regular income tax rate. The more substantial your IRA, the larger your RMD, potentially pushing you into a higher tax bracket.
Let's explore some tax-wise strategies to help you keep more of your money.
Roth IRA Conversions
One savvy move to consider is Roth IRA conversions. By converting a portion of your traditional IRA to a Roth IRA, you pay taxes now in exchange for tax-free withdrawals later.
Making a Roth conversion is a good idea if you want to contribute to a Roth IRA, but your income is above the limit to qualify to open one. By converting your traditional IRA contribution to a Roth IRA, you can legally bypass the income limits of a Roth IRA, also known as a “backdoor Roth.”
This conversion is generally a taxable event because traditional IRAs are funded with pre-tax dollars, and the conversion to a Roth IRA triggers taxation. When you convert from a traditional IRA to a Roth, the converted amount is added to your gross income for that tax year, potentially pushing you into a higher tax bracket. Imagine making $350,000 annually in 2024 (MFJ) and converting a hefty $50,000 from your traditional IRA to a Roth; you'd be reporting $400,000 for that year, pushing you from the 24% tax bracket to the 32% tax bracket.
While there's no cap on how much you can convert, wisdom lies in spreading it over several years to minimize tax liability. If your current tax rate is lower than future rates, converting to a Roth makes sense; paying taxes now at a lower rate might trump the potential higher tax on RMDs later.
It is also important to remember the nuances around the early withdrawal penalty of Roth IRA conversions. If you make a conversion, the IRS imposes a 5-year waiting period, starting from January 1 of the year of the conversion.
If you take a distribution from the Roth IRA within this 5-year waiting period, the 10% early withdrawal penalty may be "recaptured." This means the deferred penalty due to the conversion could come back into play. It's crucial to understand this because while the conversion itself avoids the immediate penalty, the subsequent distribution within the waiting period could reintroduce it.
Essentially, the IRS wants to ensure that funds converted to a Roth IRA stay there for at least five years to receive the tax advantages associated with a Roth IRA. If you need to access these funds before the completion of the waiting period, you might face the penalty initially avoided during the conversion.
Qualified Charitable Distributions (QCDs)
For philanthropic people, QCDs allow you to send your RMDs directly to a qualified charity. This fulfills your RMD requirement and keeps the distribution out of your taxable income.
Leveraging Qualified Charitable Distribution (QCD) strategically reduces taxes based on your income. However, timing is crucial. The first dollars-out rule associated with Required Minimum Distributions (RMDs) stipulates that the initial funds withdrawn from an IRA fulfill the RMD.
This introduces a timing challenge when combining RMDs with QCDs. To elaborate, these transactions must align if you plan to use a QCD to offset RMD income. You can't take your RMD and subsequently decide to execute a QCD with those same dollars. While a QCD can be done after an RMD, it will be considered an additional distribution on top of the RMD.
IRA owners should transfer their RMD amount directly to a qualifying charity before taking that year’s RMD. If done correctly, the QCD amount will satisfy the RMD amount, and no additional distribution is required.
Consider Your Tax Bracket
Regularly review your tax situation and consider strategically withdrawing additional funds from your IRA on top of your RMD in years when you find yourself in a lower tax bracket. This proactive approach can help smooth out your tax liability over time. Of course, financial advisors at Provident Financial Planning would be more than happy to take on that responsibility for you.
For example, if your annual RMD is $20,000, but you withdraw an extra $10,000 when your taxable income is lower than usual. You have spread the tax impact more evenly by withdrawing funds strategically when your tax liability is lower. This can be especially advantageous if you anticipate higher income in the following years. This is a similar strategy to what was discussed regarding Roth conversions; however, this strategy is more applicable to individuals who have reached retirement age.
RMDs are a reality, but they don't have to be a financial burden. Provident Financial Planning offers strategic planning and a keen understanding of the available tools that minimize the impact of RMDs on your retirement savings. Remember, the goal is not just to save but to maximize what you keep. Take control of your finances and enjoy the retirement you've worked hard to achieve!
Schedule an appointment with Provident Financial Planning today to discuss personalized strategies for your IRA and ensure you're on the right path to a financially secure retirement. Our team of professionals is here to help you navigate the complex world of RMDs and retirement planning. If you are also interested in planning your estate, our team, consisting of professionals with expertise in JD, CPA, and CFP®, is ready to offer comprehensive guidance. For a personalized consultation, Schedule a Zoom appointment or visit our Southlake, Plano, Dallas, Houston, or Atlanta offices.