As you approach the year you turn 73, you may start hearing more about required minimum distributions (RMDs) and why the IRS mandates these withdrawals from retirement accounts. Many retirees find RMDs inconvenient, as they can increase taxable income and potentially impact Medicare premiums and Social Security taxes. Fortunately, there are ways to minimize RMDs and make your income tax-efficient.
Here’s a breakdown of six strategies you might consider to manage RMDs and reduce your tax burden.
1. Qualified Charitable Distributions (QCDs)
One effective way to lower taxable income is through a Qualified Charitable Distribution, or QCD. A QCD allows you to transfer the amount of your RMD (or more) directly from your IRA to a charity of your choice. While you won’t get a charitable deduction, the distribution is excluded from taxable income—helping you avoid higher taxes on Social Security benefits, reducing your taxable income, and potentially lowering future Medicare premiums.
You may also be interested in: A Beginner’s Guide to Tax-Efficient Investing
2. Maximize withholding on RMDs
Another strategy is to use a 100% withholding rate on your RMD to cover taxes owed. This approach allows you to skip or reduce quarterly estimated tax payments, as the withholding is treated as though it was paid evenly throughout the year. Withholding can simplify tax planning, especially if managing quarterly tax payments has become a hassle.
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3. Convert funds in traditional IRAs to a Roth IRA
Converting some or all of your traditional retirement accounts to a Roth IRA is another way to avoid RMDs altogether. A Roth conversion does create taxable income in the year of conversion, but Roth accounts are not subject to RMDs, allowing you to grow your retirement funds tax-free and avoid future RMDs.
Further reading: IRA to Roth conversion: Should you change your retirement plan?
4. Withdraw in a low-income year
If you anticipate a low-income year, it might make sense to draw a larger portion of your traditional IRA or retirement plan. Doing so allows you to pay taxes at a lower rate and event reinvest the funds in a taxable or tax-free account, potentially lowering your future RMD obligations.
5. Keep working to avoid 401(k) RMDs
If you’re concerned about RMDs from your 401(k), staying employed with the 401(k) provider can help. As long as you don’t own more than 5% of the company, you’re not required to take RMDs from your current employer’s 401(k) plan. Even part-time work can make a difference.
6. Use a Qualified Longevity Annuity Contract (QLAC)
A Qualified Longevity Annuity Contract (QLAC) is a relatively new tool that may help lower your RMDs and taxable income. With a QLAC, you can invest up to $200,000 (lifetime limit per taxpayer) of your IRA into an annuity that delays RMDs until you reach age 85. We strongly encourage you to discuss a QLAC with your advisor before adding it to your plan—it’s not the right fit for all situations.
Here’s how it works:
EXAMPLE:
Suppose you were born in June 1951. You’re 73 years old. Your traditional IRA balance was $400,000 at the end of 2023. Your RMD this year would be your account balance divided by 26.5 (your life expectancy), for a total distribution of $15,094, according to the IRS’ formula.
But let’s say you’ve taken $200,000 from your IRA and invested it in a QLAC. You arrange to delay distributions until you turn 85. Your RMD this year would now be calculated based on a $200,000 balance, requiring you to withdraw just $7,547. That’s a difference of $7,547—and that means lower income taxes on your conventional RMD.
The $200,000 you’ve invested in the QLAC won’t be taxed until you start receiving taxable annuity payments at a later date. Keep in mind, QLAC distributions will eventually be taxed, but only when they begin later in retirement.
TIP:
Look for a joint life annuity with a cash refund option for added security and peace of mind.
A final tip to maximize tax efficiency
Always consult a tax advisor before taking action to ensure your strategy aligns with current IRS rules and your long-term financial goals. The experienced team at Financial Solution Advisors has been helping clients with financial and retirement planning for over 40 years, and we’d love to hear from you.