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

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 401(k)s. You'll eventually need to take required minimum distributions (RMDs) when you reach a certain age—and, in some cases, when you inherit a retirement account. This typically results in a bigger tax bill.

And with the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act 2.0, the ages when RMDs begin have changed. So, now may be a good time to sit down with a financial advisor to run through a few tax-efficient strategies that may help reduce your RMDs.

RMDS will be taxed as ordinary income in the year that you take them, although there are some opportunities that can eliminate the tax or defer when those RMDs must begin.

Many accounts that require RMDs are tax-deferred accounts, which means that the contributions were made with dollars you hadn’t paid taxes on, and your tax liability is due at the point of withdrawal.

Accounts that require owners to take RMDs include:

• 401(k) plans, including Roth 401(k)s
• 403(b) plans, including Roth 403(b)s
• 457(b) plans, including Roth 457(b)s
• Profit-sharing plans
• Traditional IRAs
• Simplified Employee Pension (SEP) IRAs
• Savings Incentive Match Plan for Employees (SIMPLE) IRAs
• Beneficiary IRAs (non-spouse beneficiaries of Roth IRAs)
  

Roth IRA accounts do not require RMDs.

While Roth versions of 401(k), 403(b) and 457(b) accounts are mentioned above as being subject to RMDs, they will no longer be required effective for taxable years beginning in 2024. This allows these assets to keep growing tax-free if you don’t need them at your RMD age.

The SECURE Act 2.0 has changed the ages of eligibility for taking RMDs. The RMD beginning date gradually increases to 75 over the next decade.

If you were born in:

• 1950 or earlier: Your RMD start date is at age 72
• Between 1951-1959: Your RMD start date is at age 73
• 1960 or after: Your RMD start date is at age 75

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. Once you withdraw your annual RMD, the money is taxed at your current income rate. The federal income tax impact is similar to the income you earn from working at a job—the higher your income for the year, the higher your tax rate.

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.

If you give money to charity, QCDs offer a unique way to reduce taxes associated with RMDs. Money donated through a QCD counts toward your RMDs and may reduce your taxes since you can exclude the distribution from your tax return.

Charitable giving is an important value for many. Using a QCD is one way to help reduce the funds you may have otherwise needed to withdraw as an RMD. The SECURE Act 2.0 caps the limit at $100,000 per year, with inflation adjustments beginning in 2024.

However, the SECURE Act 2.0 hasn't impacted the age you can take QCDs. That remains 70½.

Something else to note is that a one-time QCD of $50,000 is allowed through some charitable remainder annuity trusts (CRATs), charitable remainder unitrusts (CRUTs) or charitable gift annuities (CGAs). This change expands the types of charities that can receive a QCD, presenting another opportunity to provide a meaningful gift while potentially reducing your tax burden.

For these gifts to count toward your RMDs, the contributions must come from your IRA by Dec. 31 each year.

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, especially with the recent SECURE Act 2.0 changes.

You can also temporarily reduce RMDs with a QLAC, a type of deferred income annuity.¹ With this approach, you move a portion of your savings from tax-deferred accounts into a deferred annuity that meets specific IRS requirements.

The annuity company turns your contributions into payments, which you can delay until 85. Once you elect to take those payments, they're for the rest of your life.

You can invest up to $200,000 of a retirement account to shield those funds from RMDs.

While you can use a QLAC to postpone your RMDs, once you begin taking them, the distributions are included in your taxable income, so it's critical to plan for a potentially higher income in those years.

If you're still working at age when you reach RMD age and don't own more than 5% of the company you're working for, it may be possible to postpone RMDs.

However, there are a few qualifiers:

• The postponement is only eligible for employer-sponsored plans such as a 401(k) and 403(b).
• If you own another 401(k) from previous employers, you still need to take RMDs from it. That said, it may be possible to work around this requirement if your current employer's plan allows for rollovers.² In that case, you can roll the funds in other 401(k)s into your current plan and you don't have to take an RMD until retirement.

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).

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 25% 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. If you fix the error during the Correction Window,² the penalty drops to only 10%. Work with a tax professional to find out if a penalty waiver might be available if this applies to you.

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.