You’ve worked hard and saved for years, and now the time has come to start utilizing your life savings. Even if you don’t need the extra income, the IRS requires you to begin taking distributions from your traditional IRA or employer-sponsored accounts at a specific age. Since your contributions have been tax-deferred, Uncle Sam wants to cash in on his patience. To make the best use of these withdrawals, you must develop smart strategies for managing your RMDs.
If you don’t plan on using each distribution to support your lifestyle, there are some key decisions you need to make. Before you decide how to handle your RMDs, you need to understand what they are.
What are the Required Minimum Distributions?
Once you reach 70 ½, the IRS mandates IRA and employer-sponsored accountholders to start taking regular distributions. To calculate your appropriate distribution amount you can use the Uniform Life Table. If you don’t take the mandated distributions or you fail to take enough, you could face a 50% excise tax on the amount that wasn’t distributed as required.
Now that you understand what RMDs are, here are a few key questions that can help you begin thinking how and when to use your RMDs.
- Do you need the money to cover your retirement expenses? Some retirees will need these distributions to cover their basic retirement expenses. To determine if you will need income from your distributions, review your budget and estimate your expenses and cash flow.
- Do you plan to reinvest your distributions? Pension and Social Security benefits may cover your basic needs. Even if your retirement spending is not a concern, you will still need to take RMDs. Even though you cannot reinvest your distributions back into tax-advantaged accounts, there are other options to make your money grow. Three investment options you should consider include municipal bonds, exchange-traded funds and tax managed mutual funds, and stocks you intend to only hold for a year.
- Do you want to leave a legacy to your heirs? If you have grandchildren and want to leave a monetary legacy behind, you can consider using your RMDs to fund 529 accounts or Roth IRAs in their name.
- Do you want to make charitable donations? Qualified Charitable Distributions (QCD) allow you to transfer funds from your IRA custodian to a qualified charity. You can donate up to $100,000. These contributions are not included in your gross income and do not count against deduction limits for charitable contributions. If you’re a high-income earner, using this strategy for managing your RMDs could be beneficial.
Once you have an idea of how you should use your withdrawals, you can begin creating strategies for managing your RMDs. Here are a few approaches to consider.
Begin taking distributions at age 59 ½
Once you turn age 59 ½, you can begin taking distributions from your tax-advantaged accounts without a 10% penalty. Although you may be in a higher tax bracket, beginning to take distributions early on can help minimize your future tax burden. It can also decrease the size of your account, therefore lowering the amount you will withdraw once you turn 70 ½.
Distributions can also make it possible to prolong claiming your Social Security benefits. If you wait to apply for your benefits until after full retirement age you could increase your benefit by 8% to 32% (after age 70 there is no incremental benefit amount).
Convert your traditional IRA to a Roth IRA
Another strategy is to convert your IRA assets to a Roth account, which is exempt from RMDs. This makes sense in one of three situations:
- You believe you’ll be in a higher tax bracket when you distribute your funds
- You want to handle or reduce your withdrawals after 70 ½
- You want to leave a lasting legacy to your heirs with an income-tax-free asset
If you don’t need the distributions to pay for retirement expenses or have a sizable retirement income, a Roth conversion may be a viable option. You will have to pay income taxes on distributions from your traditional IRA.
If you do the conversions before you reach 59 ½, you’ll be subject to a 10% penalty. However, if you wait until after you turn 59 ½, when your RMDs haven’t kicked in, you’ll most likely be in a lower tax bracket. This will also minimize your tax burden.
Support the causes you’re passionate about by using Qualified Charitable Distributions (QCD)
If you don’t need RMDs to support your retirement expenses, you may consider donating to a cause you’re passionate about. Your custodian can transfer funds to your favorite charity using RMD dollars.
QCDs count toward your RMD amount but are not considered taxable. In order to use this strategy, your custodian must transfer the fund directly to a 501(c)(3) organization (donor-advised funds aren’t eligible). You also can’t claim the QCD as a charitable deduction on your taxes.
Contribute to 529 plans or Roth IRA accounts for your grandchildren
If you want to contribute to the prosperity of your grandchildren’s future, you can consider contributing to a 529 plan or Roth IRA for your grandchildren’s account. You will still owe taxes on the distributed amount but once you deposit the funds into an account they can grow tax-free for your heirs.
When your grandchildren apply for federal student loan aid, the government takes into account 20% of the student’s assets. If you decide to contribute to their bank account, it will increase the amount they have to pay for college. Establishing a 529 in your name with your grandchild as the beneficiary will keep the amount on a separate ledger.
To contribute to a custodial Roth IRA, the child must have earned income. The contributions you make will be gifts. Remember to take into account the IRS’s gift tax rules when incorporating these contributions into your RMD strategy.
Partner with a financial planner
Partnering with a financial planner with retirement expertise is one of the best things you can do to develop smart strategies for managing your RMDs. Retirement planners are experts in the finance industry, and they have helped hundreds of people understand and optimize all of the pieces of their financial puzzle to help increase their chances of achieving the life they’ve always dreamed of in retirement.
Not only are financial planners amazing financial resources, as you work through the process of creating your RMD strategy they can refer you to tax professionals to help you understand your tax liability. To minimize your tax burden in retirement, your financial planner and tax professional can collaborate to develop the best RMD strategy possible.
By working with a financial planner, they will encourage and direct the tough conversations to help make smart RMD decisions. They can help you review financial documents, investment accounts, retirement savings, insurance policies, and any other accounts that may involve planning your retirement distributions. The more you understand about your own financial plan, the better you will be able to manage your finances.
The bottom line
Developing an RMD strategy will help you minimize your tax burden while maximizing your assets. Enlisting the help of financial professionals is one of the best ways to create a smart strategy.
If you’re looking for a financial planning partner who can help you realize your retirement goals and help you develop a smart strategy for managing your RMDs, we have financial planning offices in Redmond, Seattle, Mill Creek, the Tri-cities region, and Denver. Our firm focuses on helping retirees and those preparing for retirement achieve financial freedom by creating a plan that shows them how they can have the income they need and want until they turn 100.
If you’re ready to take the first step to achieving your retirement goals, our team is ready to assist you. We’ve helped hundreds of couples and individuals smoothly transition into retirement with confidence, and we’d like to do the same for you.