How To Shrink High Taxes On Your Required Minimum Distributions
In the past, you needed to take required minimum distributions (RMDs) around age 70.5. This year RMDs can be taken at age 73. For younger folks reading this post, the RMD age will rise to 75 on Jan 1, 2033. The taxes could be onerous regardless of when you will need to begin taking your RMDs. Keep reading for ways to shrink your required minimum distributions and hopefully reduce some of the taxes owed along the way.
Regarding RMDs and retirement income, there are typically two types of retirees; those who need to take out more than their RMD amount to live and those who don’t need their total RMD and want to push off their tax bills as long as possible. For the most part, this article is for the latter retiree, but both can learn about some strategies to minimize tax on retirement income.
Send Your RMD Straight to a Charity
If you are both retired and looking to donate to charity, you can lower your taxes by sending part or all of your RMD directly to a charity. This is called a qualified charitable donation or QCD. When done correctly, your RMD won’t be added to your adjusted gross income, and you won’t owe taxes on the withdrawal.
A QCD will likely require more record-keeping than taking a retirement account withdrawal and writing a check to a charity. But some valuable advantages make this extra step worth it. First, it can help you avoid or minimize the high-income surtax on Medicare Part B and D. Likewise, with the vast majority of Americans taking the standard deduction, they technically wouldn’t get a tax deduction for many donations to charity. In this case, you would get a nice tax benefit from making a QCD versus taking a taxable withdrawal and writing a check to a nonprofit. A QCD may also lower the amount of your Social Security income that is taxable. (Yes, part of your Social Security will be taxable. Crazy! Right?)
Talk with your tax-planning-focused Certified Financial Planner™ to see if you could benefit from a QCD. That person can help ensure that the proper steps are taken and the appropriate documentation is given to your tax preparer so you will get all the QCD tax savings.
Reinvest Your Required Minimum Distribution
Here’s a quick reminder for those already taking RMDs and those who will be soon, just because the IRS requires you to take RMDs each year doesn’t mean that you have to spend it or let it sit somewhere. If you don’t need the money now, you can reinvest the funds into a taxable investment account to continue growing for your future retirement income needs. If you are still working, you may also be able to continue funding a retirement account to help offset the taxes due on RMDs.
Convert Pre-Tax Retirement Accounts To A Roth IRA
You may already know that you can’t transfer your RMD to another IRA. But after you take your RMD each year, you can convert some or all of your traditional IRA (or 401(k)) to a Roth IRA, reducing the retirement account balance subject to RMDs in the future. I’ve generally found the best time to do Roth conversions is between retiring and needing to take RMDs. This is often when retirees are in the lower tax brackets of their retirement years.
Remember, Roth IRA withdrawals are tax-free. They also don’t count when calculating income for how much of your Social Security is taxed in retirement. Income from a Roth IRA also isn’t used when determining Medicare surtaxes.
If you are considering a Roth conversion, plan on moving money over several years. If you try and convert a large IRA or 401(k) to an IRA all at once, you could end up with a much larger than necessary tax bill. (The more money you make, the higher your tax rate will be).
Consider Where You Are Going To Live In Retirement
Remember state taxes when looking at your expected taxes in retirement. I’m writing this post in California, which has the highest marginal tax bracket in the US. However, these California tax brackets are progressive, meaning your tax rates increase the more income you earn. Some other “cheaper” tax states have flat tax rates, or you hit the maximum tax rate at much lower income levels. In contrast, some other states have zero income taxes. I can’t cover every permutation of state-to-state moves here but consider if state taxes will be higher or lower if you are planning on moving in retirement. This could alter the optimal time to do Roth conversions.
Tax planning and retirement income planning don’t end when you leave the workforce. Tax laws will likely change numerous times between now and when you no longer have to pay taxes. This probably means death, or you just run out of money. Not a super happy way to end this post, but we will all get there someday. If we plan well, we can pay fewer taxes along the way.
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