One of the hallmark benefits of investing in a retirement plan is the ability to defer taxes on your savings and investment gains. But the IRS won’t let you get away with this perk indefinitely, and you will eventually have to start paying taxes on your savings through IRS-mandated withdrawals known as Required Minimum Distributions (RMDs).
For those that don’t necessarily need to make withdrawals on their retirement fund on a regular basis, or those that would like to postpone taxes further, RMDs can be frustrating and lead to extra taxes. First, RMDs add to taxable income, driving up your tax liability. Also, withdrawing from your retirement account means your savings are no longer in a tax-deferred account and if you reinvest the money through a regular brokerage account after the RMD, you’ll be paying extra taxes on your future investment gains as well.
If it is more beneficial for you to continue deferring taxation on your savings, as there are a few strategies you can use to avoid RMDs.
How do RMDs Work?
First, let’s back up to explain the basics of RMDs. RMDs only apply to retirement plans, like Traditional IRAs and Traditional 401(k)s, that trigger a tax on withdrawals. There are no RMDS for accounts with tax-free withdrawals, such as Roth IRAs.
The rules around RMDs vary by type of account. Traditional IRAs, for example, require RMDs each year once you turn 70 ½ years old. If you have a work retirement plan, you don’t need to make RMDs until you either turn 70 ½ or retire, whichever is later.
RMD amounts also vary, and are calculated based on your life expectancy and your account balance. To find your RMD, divide your account balance by your expected life expectancy (using a chart prepared by the IRS).
Penalties for not paying your RMD every year are among the most onerous in the tax code, at 50% of the RMD amount. For example, if your RMD is $10,000 and you don’t make a withdrawal, you’ll owe $5,000 in extra taxes that year.
So, how do you avoid RMDs if you don’t actually require those annual withdrawals to meet your needs? Roth IRAs are your best bet, and there are a few different rollover strategies to consider.
1. Make a lump-sum Roth IRA rollover
Rolling over your entire Traditional IRA or 401(k) balance into a Roth IRA has pros and cons. The year that you make the rollover, you will need to pay taxes on the entire account balance, meaning you will take a fairly sizable, one-time tax hit.
But, on the upside, you will never have to make RMDs in the future, and your savings will grow tax-free from that point on. This approach can make sense if you are in a relatively low tax bracket and have the money to pay off all your retirement plan taxes right away.
2. Spread out small transfers to a Roth IRA
Once you turn 59 ½, you can also choose to make smaller withdrawals every year from your taxable retirement plans (Traditional IRAs and 401(k)s) to a Roth IRA. By making smaller withdrawals, you can avoid getting pushed into a higher tax bracket by that extra income, and taxes on withdrawals will be fairly minimal.
The downside of this approach is that it requires more effort on your end, and you will see less tax-free growth in the future since your Roth IRA balance will accumulate more slowly than a lump sum transfer.
This strategy works best if you finish your Roth rollover before you start taking Social Security because taxable retirement plan withdrawals add to your total income, which can lead to extra taxes on your Social Security payments. Keep in mind that it usually does not make sense to delay Social Security after age 70.
Both approaches have their merits and can help you minimize if not completely avoid RMDs. By planning ahead, you can take money out of retirement plans on your schedule to make sure you have the most tax-effective approach. In the meantime, read more about making this year’s Required Minimum Distribution in our next article.