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Required Minimum Distributions: What They Are and How to Factor Them Into Your Retirement Planning
Required minimum distributions – or RMDs for short – definitely aren’t the sexiest investment topic. They’re dry, technical, and a long ways off for many people.
But if the goal of your retirement plan is for you to have enough money to do the things you want and need to do, then RMDs are an important concept to understand. They can have a big impact on the amount of money available to you in retirement, and there are some simple ways to plan for them both early on and later in your investment life.
This post explains what RMDs are, how they can impact your retirement income, and what you can do to minimize their impact.
What Is a Required Minimum Distribution?
The big draw of using a retirement account is the tax breaks it offers. Traditional accounts allow you to deduct contributions and provide tax-deferred growth. Roth accounts provide tax-deferred growth and tax-free withdrawals. It’s hard to find those benefits elsewhere.
But the IRS isn’t generous enough to allow you to enjoy those tax breaks forever, which is why they eventually require you to start withdrawing money.
Once you reach age 70.5, you generally have to start taking withdrawals from most employer retirement plans, as well as from traditional IRAs, SEP IRAs, and SIMPLE IRAs (Roth IRAs are not subject to this requirement). These forced withdrawals are called Required Minimum Distributions.
“RMDs exist because the tax deferral was not meant to last forever,” says Ken Hoyt, CFP®, a financial advisor with Perennial Advisors Group. “The IRS is essentially saying, ‘We’ve been waiting long enough to tax you on these earnings, so please start taking distributions so we can tax you.'”
The exact amount of each RMD depends on your account balance and age. Generally, the younger you are and the more money you have in retirement accounts, the more you’ll have to withdraw.
And you can’t just ignore them. There’s a 50% tax on any amounts not withdrawn, so you have to take them or pay a hefty price.
RMDs can be fairly simple or they can get complex, especially if you have multiple retirement accounts. You can review an FAQ from the IRS here, and in some situations it may be worth speaking to a CPA or fee-only financial planner for guidance.
The Major Downside of Required Minimum Distributions
At this point you might be thinking that the whole point of contributing to retirement accounts is to eventually withdraw the money in retirement, so what’s the big deal with RMDs?
The big deal is that they introduce a lack of control, especially around taxes.
According to Mike Zeiter, fee-only financial planner and the founder of Foundations Financial Planning, the major downside of RMDs comes when you have enough money from other sources to pay for your expenses. In that case, the RMD income is unnecessary and you’re forced to pay taxes on money you don’t need, which decreases the amount of money that will be available to you later on.
Vladimir Kouznetsov, CFP®, fee-only financial planner and the founder of Retegy, notes that there may be hidden tax costs as well.
“RMDs can create a number of undesirable tax consequences, like increasing taxes on Social Security payments, making more of the other investment income subject to 3.8% surtax on net investment income, and increasing ‘silent’ taxes such as an increase in Medicare premium,” Kouznetsov says.
In other words, while income is generally good, unnecessary income can simply increase your tax cost without providing any corresponding benefit. That’s the downside that RMDs pose.
How to Plan for Required Minimum Distributions Early On
Most planning around RMDs happens as you near and enter retirement, but there are a few things you can do early on in your investment life to give you more options down the line.
One strategy is to balance traditional and Roth contributions so that you have at least some retirement savings that aren’t subject to a required minimum distribution.
“If clients can afford to forego the up-front tax deduction, I recommend they make anywhere from some to all of their retirement contributions as Roth,” says Alexandra Baig, CFP®, fee-only financial planner and the founder of Companions On Your Journey. “Roth 401(k) contributions can be rolled into Roth IRAs, to which RMDs do not apply.”
Zeiter points out that financial planning software can run cash flow analyses that help you see where your retirement income will come from and how much you’ll have to pay in taxes from different accounts. That information can be used to decide which accounts you should contribute to now in order to maximize after-tax income in retirement.
The bottom line is that while you can never predict the future, there are some steps you can take early on that will give you more options down the line to minimize the impact of RMDs.
How to Plan for RMDs When Nearing and In Retirement
Required minimum distribution planning gets a lot more sophisticated once you’re nearing and in retirement. Specifically, Zeiter notes that age 60 is a key milestone for RMD planning.
“The best strategy to minimize RMD impact is to do Roth conversions after you’re retired and over the age 59.5, but before you’re required to take RMDs,” Zeiter says. “Roth conversions can be done to fill up a lower tax bracket, which would reduce the amount of RMDs taxed later at a possibly higher rate.”
Another potential workaround comes from the fact that, unless you’re a 5% owner in the company, you aren’t required to take RMDs from your employer retirement plan if you’re still working there.
“One option is to rollover some or all of your RMD eligible accounts into your current employer’s 401(k),” says Dwight Dettloff, CPA, fee-only financial planner and the founder of Winding Trail Financial Planning. “Effectively, this allows you to delay taxable income while you’re in a presumably higher tax bracket and allow those dollars to continue to grow tax-deferred.”
There are also some options for the charitably inclined.
“For a person who wants to donate money to a good cause, a good strategy could be to use Qualified Charitable Distribution,” says Kouznetsov. “Money is sent directly from the retirement account to the charity and the donation can satisfy the RMD requirement.”
There are other strategies as well, some of which can get fairly complicated. If you have a lot of money spread across multiple accounts, it may be worth working with a fee-only financial planner who can help you make a plan.
Maximizing Your Money
The bottom line is that required minimum distributions can have a big impact on the amount of money available to you in retirement, and planning for them can make it easier to reach your personal goals.
“At the end of the day, how much money you keep is more important than how much money you accumulate,” says Kouznetsov. “Having a sound distribution plan can keep taxes to a minimum and increase the amount available for you and your family.”
Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families.