How to Manage Required Minimum Distributions

These days most people have investments in some type of retirement plan. For those who are working for an employer or have been employed in the past, they’ve invested in their employer’s retirement plan, whether in a 401k, 403b, or some other type of plan. In addition, many have started their own personal retirement plans through IRA accounts that they moved former employer money into and/or contributed to on their own. In the process, they have probably taken advantage of the tax deferral that goes with those plans, receiving a current tax deduction or exempting the income for the contribution from being taxed as well as not having to pay taxes annually on the growth in the account(s). Being able to defer those taxes for a lengthy period of time is the good news of the story, but the key word here is defer. The tax benefits are the big incentive given to workers to help them save for retirement, but as the saying goes, “There is no free lunch”. While you can defer paying the tax for a while, there comes a point when the government wants to start collecting on those deferred taxes. One of the ways they do that is by mandating that you begin taking distributions from those plans once you reach a certain age in the form of Required Minimum Distributions (RMDs) as outlined by the IRS. There is no getting around the fact that you will eventually have to pay taxes, but with some planning and forethought, there are ways that you can make the best out of this mandate so that your investments are still working for your benefit.

Understanding the Requirements of RMDs
The first thing to understand about RMDs is what investments they apply to. You are subject to RMDs on any retirement account for which you did not pay taxes on the income that provided the contribution that has been shieled from tax on dividends and capital gains over the life of the account. That would apply to the money most workers contribute to their employer retirement plans as well as Traditional IRAs. For a very long time, the age at which you had to begin taking your RMDs was 70-1/2, meaning the year that you made 6 months past your 70th birthday. Technically you don’t have to take the distribution in that year and can wait until April 10th of the following year to make that year’s distribution, but if you choose to do that, you will have to take two distributions in the same tax year, so it may not be in your best interest to wait. As a result of the original SECURE Act passed in 2019 and SECURE Act 2.0 that passed in 2023, the RMD age is now 73 for anyone born before 1960 and is 75 for those born in 1960 or later. The amount you must withdraw is determined by the balance in your Traditional retirement accounts at the end of the previous year divided by a life expectancy factor determined by the IRS. Therefore, the amount of your RMD will potentially and likely change from one year to the next. Outside of the exception for the first year of RMDs, you must take it by the end of the calendar year, or if you fail to do so, you will be subject to a tax penalty of 50% of the amount you were supposed to take out. That penalty, of course, is in addition to the tax you owe on the distribution, which is the whole point of the RMD, allowing the government to finally collect on the tax money you haven’t paid throughout the years. What we have described thus far applies to retirement plans that you contributed to. However, if you inherited retirement Traditional funds and are continuing to defer taxes on that money, the calculation is a little bit different and beyond the scope of what we will cover in this article.

Using RMDs Productively
For some people, RMDs are a non-issue because they rely on the distributions from their retirement plans to supplement their other sources of income in retirement. However, for others whose income needs are largely met outside of such distributions, the RMD can end up being a nuisance and something that simply makes them pay more taxes on money they don’t really want to take out of their investment portfolio. If you fall in that second camp and have to take the money out just because the IRS is making you do it, you might as well make the most out of the distributions you are required to take. There are a number of ways to do that, but here are three ways you can make good use of taking money out that you otherwise wouldn’t want to:

1. Funding Life Insurance – By using the RMD to pay the premium on an existing or new life insurance policy, you are taking a portion of your taxable asset and creating a larger pool of tax free assets for your beneficiaries.

2. Re-Investing the Proceeds – If you want to make sure the funds stay invested, you can maintain the investments as they are by re-registering the investment to another account type and paying the taxes owed out of pocket or taking the amount remaining after taxes have been withheld and investing them elsewhere. This approach could be used for investments meant to serve you or others (e.g. funding a college funding account for children/grandchildren).

3. Using the Qualified Charitable Deduction (QCD) – If you make gifts to charity, by sending funds directly from your retirement account to the charity of your choice, you can achieve your desire of supporting the charity but not have to count the distribution from your retirement plan as income on your taxes because the income is offset by the deduction.

In the first to examples, you still must pay the tax, but you are still using the funds from your retirement investment to build wealth for yourself or others. With the QCD, you essentially avoid having to pay the tax at all, while at the same time supporting a charity that you may have intended to help anyway.

Executing the Roth Conversion to Mitigate the Requirement
What if you could avoid the RMD altogether? One way of doing that is to convert your Traditional retirement assets to Roth retirement assets, which allow for tax free distributions when the necessary requirements are met. Once again, there is no free lunch. In order to convert your Traditional assets to Roth assets, you will owe tax on the amount of assets you convert in that particular tax year. However, once you have converted those assets, any growth you receive after that time is available to you tax free, along with the amount that you converted because you paid the tax on that when you made the conversion. Those newly converted Roth assets are not subject to RMDs because they would generate no tax money for the government anyway, so you can hold onto those funds as long as you want, and take the money out when you want to. You may be thinking, the problem with this strategy is paying the tax on the converted assets, which could be significant if you hold a large amount in your Traditional retirement accounts. But a Roth Conversion does not have to be an all-or-nothing proposition. One approach you could consider is to execute a series of smaller Roth Conversions over a period of years in amounts that allow you to better manage the amount of tax you have to pay each year you make a conversion. This approach is likely to be one that is more feasible before you reach your RMD age because you cannot use a conversion to serve as your RMD. As a result, if you attempt to do a Roth Conversion while you also are taking RMDs, you have increased the amount of taxes you will owe. On the other hand, if you were to convert one third or half of your Traditional retirement assets to Roth assets, that serves not only to lessen the taxes you have to pay each year on the RMDs unnecessarily, but you also have created a pool of assets from which you can make withdrawals that you are not required to pay any taxes on.

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