Uncle Sam can be one of your key partners in your retirement saving. If you have money in a traditional IRA or an employer-sponsored retirement plan, then that money automatically receives tax-deferred status in the eyes of the IRS. Other accounts like SIMPLE IRAs and SEP-IRAs also benefit from this tax-favorable treatment.
Generally, your contributions to those accounts are tax-deductible. The money inside the account grows tax-deferred, or without taxes on the earnings over time, as long as withdrawals aren’t taken.
But you can’t enjoy this tax-deferred growth forever. Required minimum distributions are one way that Uncle Sam ultimately collects his tax dues.
Once you reach age 70.5, the IRS sets required minimum distributions (or RMDs) for you. You will be required to start pulling a certain amount of money out of your traditional IRAs and qualified plan balances every year. The same goes for other kinds of IRAs with pre-tax money status. And this money will be taxed at your top marginal tax bracket, regardless of how long it's been in the account.
There is no capital gains treatment available for traditional IRAs and qualified plans, save for one exception. The sale of company stock held inside a 401(k) plan can be spun off and sold separately under the Net Unrealized Appreciation (NUA) rule.
How Do Required Minimum Distributions Work?
Required minimum distributions must be taken from your traditional IRAs and qualified plans no later than April 1st of the year after the year in which you turn 70.5. So if you turn 70 .5 in 2019, then you will have until April 1st of 2020 to start taking your RMDs.
If you wait to take distributions any longer than this, then the IRS will levy a 50% excise tax on the amount that you should have withdrawn by the deadline. They will also tax the amount you should have withdrawn.
So, there is absolutely no advantage to trying to defer your retirement payouts past this deadline. RMDs must also be taken by December 31 of every year thereafter.
The vast majority of IRA and qualified plan custodians will notify their customers when the time comes to start taking their required minimum distributions (RMDs). They do this as a courtesy to them.
They will also compute the amount of money that must be withdrawn each year, thus saving their customers from having to look up the amount in the actuarial tables published by the IRS.
These tables show the annual multiplier for RMDs each year, which are based on the taxpayer's life expectancy.
How to Calculate Required Minimum Distributions
You can compute a rough estimate for your required minimum distribution for a given tax year. Follow these steps to arrive at an idea of the minimum withdrawals you must take from your qualified account:
1. Look at the table, locate your age, and find the corresponding Distribution Period.
2. Take the value of your account, and divide it by the applicable Distribution Period. For example, say you have a traditional IRA with $1 million and your age is 70.
3. $1,000,000/27.4 is $36,496.35 for your first estimated RMD. This is a rough estimate of what you will be required to pull out for the year.
Keep in mind this is taxed as ordinary income, not as capital gains. Depending on where you live, your state may also want a piece of your withdrawn amount for your RMD as well.
But not all states do, according to Kiplinger. As of February 2019, the following 12 states don't tax traditional IRA or qualified plan distributions:
- New Hampshire
- South Dakota
Manage RMDs with Qualified Charitable Distributions
You have several ways to reduce the amount of taxable distributions that you have to take each year in retirement. One of them is by making qualified charitable donations to your favorite charity.
The IRS will allow you to divert up to $100,000 of your IRA and qualified plan distributions directly to a qualified charity every year. Thus, you will avoid paying tax on the distribution.
The distribution must go directly to the charity without coming to you first. But if you already make regular contributions to one or more charities, then this strategy could help to keep you in a lower tax bracket in retirement, helping you save a substantial amount on taxes.
Use More Tax-Free Income Sources
Converting some of your traditional IRAs and qualified plans to Roth accounts can be another good way to relieve your tax bill from RMDs. Roth IRAs don't have RMDs of any kind, since the money that can be withdrawn from is tax-free.
Be sure to consult your tax advisor for more information about this strategy. They can help ensure that you receive optimal tax treatment on your conversion.
Another good strategy is to possibly tap other types of tax-free vehicles. If it is appropriate for your financial situation, another possibility is cash value life insurance.
A properly-structured index universal life insurance policy with accelerated benefit riders can be a source of tax-free funds during retirement. This type of policy is linked to an underlying financial benchmark, such as the Standard & Poor's 500 Index. It will pay you interest when the underlying benchmark rises in value.
But if the benchmark declines in value, you will not lose any money due to the index losses.
The accelerated benefit riders can also help protect you against the high costs of disability or long-term care. Most of them will start paying out if you become unable to perform at least 2 out of the 6 activities of daily living (ADLs).
You cannot take a deduction for the amount of money that you contribute into one of these policies, but they also do not have any RMDs that must be taken.
Other Strategies for RMD Management
Finally, you may want to consider tapping for income a regular taxable brokerage account. This can be an excellent place to buy and hold shares of stock.
You can get capital gains treatment out of them if you hold them for a year or longer. You can't get capital gains treatment inside a traditional IRA or qualified plan no matter how long you hold the shares (except under the NUA Rule as described above).
Start Your Tax and Retirement Planning Now
Consult your financial professional today for more information on how your retirement plans and accounts will be taxed after you stop working. Your required minimum distributions may be avoidable in some cases if you pursue one of the strategies described above.
What if you are looking for personal guidance from a financial professional -- or you simply want a second opinion of your current situation? Help is a click away at Jennifer Lang Financial Services. Contact us today.