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How are RMDs taxed & can you reduce their tax impact?

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Pascal Broze/Getty Images/Onoky

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 tax efficient strategies here.

How are RMDs taxed?

An RMD is often a distribution from a retirement account. As a result, the amount you withdraw is treated as ordinary income. You generally add that income to other income sources on your tax return, and any deductions on your return could potentially reduce your taxable income.

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 when each account is taxed. However, you might have some control over the timing and amount of your withdrawals. Any strategy has pros and cons, and it's critical to review your situation carefully with a certified public accountant (CPA) and financial advisor before making any decisions.

Explore qualified charitable distributions (QCDs)

If you give money to charity, QCDs offer a unique way to reduce taxes associated with RMDs. To use this strategy, you send money directly from your retirement account to a qualifying charity. When you meet the requirements for a QCD, the distribution may be excluded from your federal income tax return. However, you're still taking a distribution—and that withdrawal can potentially satisfy your annual RMD. As a result, you may not owe income taxes on the RMD.

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Charitable Strategies: Qualified Charitable Distributions QCD

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 convert money from tax-deferred retirement accounts (like a traditional IRA or 401[k]) into Roth accounts.1 When you do so, you owe taxes on the amount you convert, so you're essentially choosing to prepay taxes by moving assets out of those tax-deferred accounts before the IRS requires you to take RMDs.

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.

Run the numbers using our Roth IRA calculator and talk to a financial advisor to learn more about how Roth conversions might look for your situation.

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.

Read more about the pros and cons of QLACs.

See if you can delay RMDs while working

If you're still working at age 72 and beyond, it may be possible to postpone RMDs. When you have funds in your employer's defined contribution plan, you might be allowed to delay RMDs until you retire. Eligible plans include 401(k)s and 403(b)s.

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, speak with a financial advisor who can analyze your situation. While Thrivent does not provide specific legal or tax advice, we can partner with you and your tax professional on the best step forward.

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1State tax rules may differ from federal rules governing the tax treatment of Roth IRAs and there may be conflicts between federal and state tax treatment of IRA conversions. Consult your tax professional for your state tax rules.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.