By: Joseph Hill, Jr., CPA, MBA, MSF | Tax Manager
After investors reach age 70 ½, “the tax man cometh.” That’s when the IRS requires mandatory withdrawals from traditional Individual Retirement Accounts (IRAs), employer-sponsored retirement plans such as 401(k)s, 403(b)s, 457s, and the federal Thrift Savings Plan. The total amount of this mandatory withdrawal—or required minimum distribution (RMD)—is taxed as ordinary income at each taxpayer’s respective individual federal income-tax rate. State and local taxes may also apply to these withdrawals from retirement accounts. While RMDs are structured to aid in the gradual payment of taxes owed on retirement assets, there are some strategies to taking those withdrawals that can save individuals money.
The first RMD must be taken no later than April 1 of the year following the calendar year in which an individual reaches age 70 ½. After the initial RMD, all subsequent RMDs must be distributed by December 31 each year. Delaying the first RMD until April 1, however, would require two distributions in the same year, because the second distribution must be taken by December 31. Taking two distributions in the same year could significantly increase the tax obligation, trigger alternative minimum tax, and may require additional federal income taxes on Social Security benefits.
Many retirees have more than one retirement account. Having more than one IRA requires calculating the RMD separately for each, but the total withdrawal can come from a single account or from a combination of two or more accounts. The same rule applies for multiple 403(b) accounts. To avoid paying more than is necessary, someone who has multiple accounts should consider withdrawing from the IRA that is most advantageous.
Likewise, having multiple 401(k)s and 457(b)s requires an RMD from each. An individual who is still working after age 70 ½ can delay distributions from
his/her current 401(k)—but not from an IRA—until April 1 of the calendar year after retiring. Failing to take an RMD or taking too small of a distribution could result in a 50 percent excise tax on the amount not distributed. Consolidating multiple IRAs into a single IRA could reduce the probability of a calculation error. Moreover, some IRAs offer automatic RMD plans, but the amount calculated automatically isn’t always in the taxpayer’s best interest.
If the RMD is not needed for living expenses, the distribution might be considered an annual financial nuisance. However, these withdrawals could be converted into opportunities. For example, an individual could deposit the RMD into a brokerage account and invest those dollars according to the individual’s overall retirement plan, or a grandparent could start an education fund for a grandchild. In addition, rather than taking the whole distribution at the end of each year, distributions could be spaced throughout the calendar year to obtain a range of sale prices for longer-term assets. In these cases, consultation with a financial planner and/or an investment advisor is recommended, in order to maximize these opportunities.
What about withdrawing more than the RMD? This is permitted, but excess withdrawals will not be applied toward future RMDs. In other words, an individual will still need to take at least the RMD amount each year, even if the taxpayer has taken more than required in the previous year. There might be times when it makes financial sense to take more than the minimum, but not if the intention is to reduce future distributions.
As in other areas, the rules are slightly different for Roth IRAs. RMD rules do not apply to the original owner of a Roth IRA. (However, RMD rules do apply to the beneficiary of an inherited Roth IRA.) Converting excess withdrawals to a Roth
IRA in years of small or no taxable income would add tax diversification and flexibility to the retirement withdrawal. Consultation with a financial advisor and a tax advisor can help to determine if a Roth conversion is in someone’s best interest.
To minimize the tax on RMDs even further, assets can be placed in a diversified portfolio. Placing low-growth assets in traditional IRAs and high-growth assets in Roth IRAs will reduce the RMD, and the Roth IRA growth will be accelerated in a tax-favorable account. “Bucketing” IRAs and retirement-plan assets is a strategy by which assets are divided into short- term cash or cash-like accounts to help address RMD and other income needs, intermediate-term assets (such as bonds) that are next in line for distributions, and long-term assets. Working with an investment advisor to diversify and allocate assets in a portfolio is strongly recommended.
Even though RMDs cannot be avoided, there are options available within the set of requirements. Consult with an investment advisor, financial planner, and/or a tax professional for advice specific to your situation.