Retirement accounts can help you manage taxes during your working years and throughout your life. But nothing lasts forever, including tax deferral from accounts like traditional IRAs and 401(k)s. You'll eventually need to take required minimum distributions (RMDs), which typically results in a bigger tax bill.
Several strategies can help reduce your RMDs. We'll explore the basics and some
How are RMDs taxed?
The federal income tax impact is similar to income you earn from working at a job—the higher your income for the year, the higher your tax rate.
How to manage taxes on RMDs
When you have money in retirement accounts, you'll generally have to pay taxes on that money at some point, depending on
Explore qualified charitable distributions (QCDs)
If you give money to charity,
Your RMD is based, in part, on your account balances. With smaller account balances, you should have smaller RMDs. One way to reduce your account balances is to
Why would you pay taxes early? It doesn't always make sense, but in some cases, the strategy can be beneficial. It can be particularly helpful in years where you have a low income (and you're presumably in a low tax bracket). If your tax rate is lower when you convert than it would be when you expect to take RMDs in retirement, there could be some arguments for converting at least a portion of your pretax assets.
Evaluate postponing RMDs with qualified longevity annuity contracts (QLAC)
You can also reduce RMDs—at least temporarily—with a QLAC. With this approach, you move a portion of your savings from tax-deferred accounts into a deferred annuity that meets specific IRS requirements. By doing so, the assets you put in a QLAC can be excluded from your RMD calculation. Again, with smaller balances, you have smaller RMDs.
While QLACs can ease the burden of RMDs for a while, you eventually need to take RMDs from your QLAC. However, you can wait until age 85 to begin those withdrawals, and you're allowed to start taking payments from a QLAC earlier if you prefer. Once you begin taking income, you typically get a stream of payments that should last for your entire life. Those distributions are generally included in your taxable income, so it's important to plan for a higher income in those years.
See if you can delay RMDs while working
However, the "still working" exemption isn't always available. For starters, not all plans permit you to delay RMDs. Plus, if you own more than 5% of the company you work for, IRS rules do not allow you to postpone RMDs. Check your plan details to see what is allowed in your situation.
Should you have taxes withheld from your RMD?
You usually have the option to pay a portion of your RMD to the IRS for withholding. Doing so can reduce the amount you pay at tax filing time, and it could also help you avoid underpayment penalties and interest. But that also means you may have less cash flow, and you can't know for certain how much your tax bill may be.
As a result, it's wise to review your income and deductions regularly with a tax expert. They can help you dial in the right withholding amount (if any).
Take your RMDs on time
It's critical to follow IRS rules and take your RMDs as required. If you miss an RMD, the penalty is steep: You owe the IRS 50% of the amount you were supposed to withdraw. That's an unnecessary cost, but sometimes, life happens, and you're unable to take a distribution (or you withdraw less than is required).
Fortunately, it may be possible to plead your case with the IRS, especially in extreme circumstances. Work with a tax professional to find out if a penalty waiver might be available.
Design your RMD strategy
You now know more about how taxes can affect RMDs, but don't stop here. To learn more about tax-efficient retirement strategies,