The benefits of contributing to traditional retirement accounts, like a company 401(k) or personal IRA, are numerous, and one of the most significant ones is gaining capital appreciation in tax-deferred accounts.
But tax-deferred today doesn’t mean tax-free tomorrow.
You contribute with pre-tax dollars in traditional retirement accounts, and your investments grow tax-deferred for decades. But you have to pay Uncle Sam at some point, so once it’s time to retire, the IRS taxes your distributions as ordinary income.
Most retirement accounts also have required minimum distributions (RMDs), and depending on your tax situation, they can increase your taxable income and, therefore, your tax burden.
The good news is that there are ways that you can minimize your tax pain. Let’s take a look at four smart ways retirees can approach their RMDs in 2022.
What Are Required Minimum Distributions?
To receive tax-deferred capital appreciation, the IRS requires that you begin taking distributions from certain retirement accounts at a certain point during your retirement.
Remember, the money in your retirement accounts can’t grow tax-deferred forever. The IRS created a system for people to withdraw a set amount of money from specific retirement accounts throughout retirement—a system called required minimum distributions.
Nearly every retirement account has RMDs—except Roth IRAs. So, when do these rules go into effect for you?
You have to take RMDs from all necessary accounts by April 1 of the year after you turn 70½ if you were born before July 1, 1949, and April 1 of the year after you turn 72 if you were born after Jun 30, 1949.
Accounts that have required minimum distributions include:
- Traditional IRAs
- SEP IRAs
- SIMPLE IRAs
- 401(k) plans
- 403(b) plans
- 457(b) plans
The required minimum distribution amount depends on your accounts’ balance. The IRS provides worksheets to help you calculate the amount. You can withdraw more than the required minimum distribution, but you can’t withdraw less than that specified amount. If you do, the IRS could stick you with a 50% penalty, plus income tax on the distribution.
1. 401(k)s from Current Employers
One exception to the required minimum distribution rules is 401(k)s sponsored by your current employer. If you’re still working, you don’t have to take an RMD if you own 5% or less of the company you currently work for.
Keep in mind that this unique rule does not apply to 401(k) plans that you might have left behind at former employers.
2. Qualified Charitable Distribution
Qualified Charitable Distributions (QCDs) are another way to get around the required minimum distribution rules.
Taxpayers who are 70½ or older can make distributions directly from IRAs to qualified charities and satisfy the required minimum distribution rules in the process. For example, if you give money to your church or another non-profit organization, you can use the QCD instead of drawing from your other savings.
The amount of the QCD (up to $100,000 per year) will not be taxed to you. In addition, the QCD counts toward fulfilling your annual RMD—a win-win! A QCD could be an excellent solution if you were planning on giving to charity anyway and want to lessen your tax burden at the same time.
3. Qualified Longevity Annuity Contract
The Qualified Longevity Annuity Contract (QLAC) is a type of annuity that pays a guaranteed monthly income sometime in the future in exchange for a lump sum deposit today. You can deposit up to 25% of your retirement balance to a maximum of $125,000 per taxpayer.
For example, suppose that you have $500,000 in your IRA, and you deposit $125,000 into a QLAC. Your taxable RMD will now be calculated on $375,000 instead of $500,000, which should save you current income taxes.
4. Roth IRA Conversions
Another option for lowering your tax burden is a Roth IRA conversion. Taxpayers can convert some or all of their taxable IRA accounts into tax-free Roth IRA accounts.
When they do, they must pay income taxes on the conversions immediately. However, since Roth IRAs are not subject to RMDs, the eventual tax savings can be significant.
Once you convert your account, the balance can continue to grow tax-free in retirement. Since Roth IRAs have no required minimum distributions, you’ll also have more flexibility if and when you decide to tap into these funds.
If you’re considering a Roth IRA conversion, you should discuss the potential benefits with your financial advisor to ensure it’s right for you.
The Bottom Line
At Goepper Burkhardt, we help our clients minimize their RMDs as part of our comprehensive financial planning services.
It’s important to note that tax strategies like Qualified Charitable Distributions, Qualified Longevity Annuity Contracts, and Roth IRA Conversions are fairly complicated. They require a significant amount of explanation before they are implemented, which means that we strongly recommend that you work with a financial advisor and tax professional if you’re considering any of these strategies.
Not only can financial advisors help you craft a tax strategy for retirement, but they can also help with other retirement-related financial issues, like creating a retirement income and spending plan and assisting with estate and legacy planning.
Tax laws also change from year to year, so it’s a good idea to work with a professional to stay aware of the latest developments. If you’re nearing retirement and need knowledgeable advice about how to handle your finances, we’re here to help. Get in touch with us today to learn more!