How to Avoid Taxes on Required Minimum Distributions

Required Minimum Distributions (RMDs) are mandatory withdrawals from tax-deferred retirement accounts. These distributions begin once an account holder reaches a specific age and are generally taxable as ordinary income. Effectively managing RMDs is important for optimizing tax outcomes in retirement.

Understanding Required Minimum Distributions

RMDs are annual withdrawals from traditional Individual Retirement Arrangements (IRAs) and employer-sponsored retirement plans, such as 401(k)s, 403(b)s, and 457(b)s. This requirement also extends to Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs. These rules ensure the government collects tax revenue on tax-deferred growth within these accounts.

The age at which RMDs must commence has changed due to recent legislation. Currently, RMDs generally begin at age 73. The law is scheduled to increase the RMD age again to 75 starting in 2033.

Calculating an RMD involves the account balance at the end of the previous year and the account holder’s life expectancy factor, as determined by IRS tables. Account custodians typically provide this calculation or the necessary information. Failing to take the full RMD by the deadline can result in a 25% penalty on the amount not withdrawn.

Strategies for Reducing Taxable Distributions

Several strategies exist to reduce the taxable amount of current RMDs or delay their commencement. These methods focus on direct actions that impact the immediate tax liability associated with these mandatory withdrawals.

Qualified Charitable Distributions (QCDs) allow individuals aged 70½ or older to transfer up to $105,000 annually from their IRA directly to an eligible charity. While a QCD counts towards satisfying an RMD, the transferred amount is excluded from taxable income. The funds must go directly from the IRA to the qualified charitable organization and cannot be received by the account holder first.

Investing in Qualified Longevity Annuity Contracts (QLACs) is another option. A QLAC is a deferred annuity purchased within an IRA or 401(k) that allows a portion of retirement savings to be excluded from RMD calculations until a later age, up to 85. Individuals can allocate up to 25% of their aggregate account balance, or a maximum of $200,000, whichever is less, into a QLAC. This strategy reduces the current RMD base, deferring tax obligations.

The “still working” exception allows some individuals to delay RMDs from employer-sponsored plans. If an individual is still employed by the company sponsoring their retirement plan and does not own more than 5% of that company, they can delay RMDs from that specific plan until they retire. This exception applies only to the employer’s plan and does not extend to RMDs from traditional IRAs.

Proactive Planning with Roth Conversions

Roth conversions offer a long-term strategy to eliminate future RMDs and create tax-free income in retirement. This involves moving pre-tax money from a traditional IRA, 401(k), or other qualified retirement plan into a Roth IRA.

The converted amount becomes subject to income tax in the year of conversion. This means the individual pays taxes on the principal and any accumulated earnings at their current marginal tax rate. Despite this upfront tax cost, the long-term benefits can be significant, particularly for those who anticipate being in a higher tax bracket during retirement.

Roth IRAs are not subject to RMDs for the original owner, allowing funds to remain invested for continued tax-free growth. Qualified distributions from a Roth IRA in retirement are entirely tax-free, providing income that does not increase taxable income or affect Medicare premiums.

Consider your current versus anticipated future tax bracket for Roth conversions. Converting funds when in a lower tax bracket can be advantageous. The conversion’s impact on adjusted gross income (AGI) and eligibility for other tax credits or deductions should also be considered. Converted amounts must remain in the Roth IRA for at least five years to be qualified and tax-free upon withdrawal.