Think About RMDs Before You Turn 70Submitted by Mission Financial Planning on August 26th, 2016
Updated for the new SECURE Act: For any individual born after June 30, 1949, the required beginning date for Required Minimum Distributions (RMDs) is April 1 of the year after the year in which such individual reaches age 72 (or, in the case of certain plans, if he or she is still working, after the year in which he or she retires if later). Previously, the trigger age was 70½.
We've spent several weeks covering Required Minimum Distributions (RMDs). Previous posts in the RMD Series include RMD Basics, RMDs for Business Owners and Employees, How RMDs Work in Real Life, Using an IRA for Charitable Contributions, and What Happens When You Forget to Take an RMD. In this post we’ll address a strategy that can be employed a few years before your Required Minimum Distributions kick in.
We know that RMDs create a taxable event. Once RMDs are required (from age 72 on), there isn’t much that can be done about managing their tax consequences, other than using them to make a Qualified Charitable Distribution. However, prior to age 72, there are some strategies that you can consider that will potentially reduce your future RMDs as well as managing the taxes paid on those distributions.
One strategy helps when you have a year or more when you anticipate lower-than-usual and/or lower-than-future taxable income, prior to age 72. This lower tax bracket is usually due to retirement (no earned income), and the ability to live off after-tax accounts.
This concept may be easiest to explain in an example. Let’s imagine that Dr. Jones sells his dental practice at age 65 and has set aside the sale proceeds in an after-tax account. We’ll also assume that he has significant pre-tax investments built up from contributing to his 401(k) over many years. In the years after the practice sale and before RMDs are required, he could potentially be in the lowest tax bracket he’ll be in for some time. If he doesn’t have earned income, his only taxable income may be dividends and capital gains from any after-tax investments, and possibly Social Security. Conventional wisdom would suggest that he live off the after-tax money, and enjoy those low-tax-bracket years until the RMDs kick in. However, it might be prudent to withdraw money from the IRA, either for living expenses or to convert to a Roth IRA, and have those withdrawals taxed while he’s in this low bracket. This may accomplish a few goals:
Get the IRA withdrawal taxed in a lower bracket than it might be in the future
Reduce the IRA balance, therefore reducing potential “forced” RMD withdrawals.
If he converts the money to a Roth IRA, future growth is moved to a “tax free” environment.
Individual circumstances will dictate the effectiveness of this strategy; spending levels, the ratio of pre- and after-tax investments, taxable income and available tax deductions and credits all need to be considered when deciding whether this is an effective strategy for a particular situation. In some projections, we’ve seen only nominal changes over the life of the portfolio. In others, the differences have been dramatic. A tax-efficient withdrawal strategy can, in some cases, extend the life of a portfolio that would otherwise spend down too soon.
We use sophisticated software to model and test withdrawal strategies using a multi-year approach. We can target the withdrawals to stay within certain tax brackets, reduce how much of the Social Security benefit is taxed, or stay below an income threshold used for determining Medicare premiums, for instance. There are a lot of moving parts to the equation, but the rewards of implementing an intentional and efficient withdrawal strategy can be significant.
For those with charitable goals, another strategy is to take advantage of the time after age 70.5 when you can make charitable donations straight from your IRA to a 501(c)3 charity. You can start this age 70.5 and make contributions up to 100,000 per year from your IRA. This has the effect of reducing your IRA balance, thus reducing your future RMD (starting at age 72) but has no current tax ramifications. Here's more info on that strategy.
It may help to have someone to guide you through the details and limitations of the strategies above, we'd love to help.