You saved up all your life for retirement, squirreling money into individual retirement accounts or 401(K)s and the like. And that reduced your taxes because the retirement contributions were deducted from your income. But once retired, you can’t just sit on this tax-sheltered money. By law, at 70½, you must take some of it out, based on your life expectancy, called a required minimum distribution. The downside: Taking an RMD pumps up your taxable income. Stephen Nelson, a wealth manager at Aldrich Wealth in Carlsbad, Calif., has some tips on lessening the Internal Revenue Service bite:
Larry Light: For those that don’t need the income, are there ways to lower the tax hit of an RMD?
Stephen Nelson: The IRS mandates that RMDs are to start once someone turns 70.5. This will affect all taxpayers who own IRA accounts or who have 401(k) and are no longer working. These distributions will get taxed at ordinary income rates, instead of the more favorable capital gains rates that typically happen whenever you sell a security for a gain.
Remember all those hard-working years when you got a tax deduction for contributing to retirement? Well, the IRS has said, “enough,” and is making you pay the taxes you owe by forcing you to take distributions each year.
But there are a few things that Americans can do to fight back and lower their tax bite.
Light: What can you tell me about these strategies?
Nelson: First off, if a person is still working with his or her company, they may be able to forgo taking RMDs from their 401(k) as long as these employees don’t own more than 5% of the company and their plan doesn’t mandate distributions at age 70½. If this is the case, they can push off taking RMDs until they stop working.
If this employed individual also has an IRA and the 401(k) plan allows for rollovers, you can transfer your IRA into your workplace 401(k) before you turn 70, which will delay the RMD requirement since everything is now in your 401(k) at work.
An important side note. If you plan to work past 70½, don’t schedule your retirement date for the last day of the year because then you’ll be required to make a distribution for the year you retire in. It would be better to retire earlier in the year or better yet, on January 1st of the next year to push off your RMD until the following tax year.
Light: Is there more someone can do to reduce the tax bite from RMDs?
Nelson: Absolutely. If someone regularly gives to charity or church, they can use part or all of their RMD for their charitable contribution. The donation will go directly from their IRA to the charity. It will count for your RMD, but it won’t count as income, so you don’t pay any taxes on that withdrawal! This is called a Qualified Charitable Distribution or QCD and is limited to $100,000 each year. If you’re charitably inclined, this is the most tax-efficient way to give.
Furthermore, even though you’re allowed to delay your first RMD until April 1st of the following year after you turn 70½, don’t delay because then you’ll have to take two withdrawals in that year and will pay more in taxes.
Light: Any other benefits for decreasing income from RMDs?
Nelson: Yes, in retirement, an individual’s income determines how much they have to pay of income tax on Social Security, how much their Medicare premiums, and if they’ll be subject to the 3.8% surtax on net investment income. By lowering your income in retirement, most of these can be reduced or in some cases eliminated completely.
Light: Is there anything you can do before you reach 70½ and have to start taking RMDs?
Nelson: You could implement a strategy called tax bracket management, which means taking distributions from your IRA early to fill up the lower tax brackets before RMDs bump you into higher brackets.
Say you’re slowly phasing out of working and are earning less money and are planning on delaying Social Security until 70. You can start taking distributions from your IRA while you’re in the lower tax brackets and may pay nothing in taxes on those distributions.
For example, the current standard deduction stands at $24,400, assuming 2019 tax rates and a married filing jointly status. This means that you would owe little to no taxes on a $24,400 distribution from your IRA as the standard deduction wipes it out. However, this may bump any other income you earn or receive into higher brackets, so be sure to check in with your accountant.
By accelerating distributions from your IRA before you turn 70½, not only will you pay fewer taxes due to the lower tax brackets, but also this will decrease your IRA account balance, which will lower the amount you’ll have to take as an RMD and decrease the taxes you’ll pay in the future when tax rates might be higher.
Always speak to your accountant and advisor before implementing any of these strategies as every situation is different.