Based on IRS guidelines, at age 72 an individual must begin withdrawing a minimum amount out of their retirement account(s) annually. This is known as a “Required Minimum Distribution” (RMD) and is fully taxable. The RMD is calculated using the prior year-end balance of a retirement account, divided by a factor from the IRS Mortality Tables (1). That percentage increases each year. Given the RMD starts at age 72, what can you do to reduce or manage your tax burden?
Beginning at age 59 ½, IRS guidelines permit withdrawals from retirement accounts without penalty. If retiring between ages 59 ½ and 72, an initial strategy to manage the tax burden of RMDs is to start withdrawing money from retirement account(s) to supplement other sources of income, such as Social Security and pension. Typically, an individual’s income is less in retirement than when he/she were working. The lower income provides the ability to take withdrawals from retirement accounts and remain within his/her current tax bracket. The withdrawals reduce retirement savings over multiple tax years thereby spreading out the tax liability and reducing eventual RMDs beginning at age 72. This strategy is most effective for those who have multiple years in retirement prior to age 72.
Roth IRA conversions are another strategy to reduce RMDs. This strategy involves investments being withdrawn from a Traditional IRA and moved into a Roth IRA. This withdrawal is taxable but once those investments are in a Roth IRA they grow tax free and are excluded from RMDs. Similar to the first strategy, this strategy is more beneficial from a tax perspective if done over multiple tax years.
Lastly, for those who are closer to turning age 72, or have already begun withdrawing their RMD, another alternative is to donate all or some of the RMD to charity. Charitable contributions are tax free and satisfy the minimum distribution requirement. This strategy is known as a “Qualified Charitable Distribution”.
An individual’s tax situation must be taken into account along with their retirement goals before initiating any tax strategies. It is always recommended to speak with a tax advisor who can apply these strategies to an individual’s specific tax situation.