What are Required Minimum Distributions (RMDs)?
As you approach retirement, you’ll encounter a lot of acronyms. One acronym you should understand and be prepared for are RMDs (short for Required Minimum Distributions). Now, you may be wondering “What are Required Minimum Distributions?” In this brief article, we’ll talk about RMDs, the tax implications, and how you can better prepare for them.
Let’s dig in!
Pre-tax retirement accounts are some of the most common types of retirement accounts – for example, 403bs, 401ks, and Traditional IRAs. These pre-tax accounts typically provide you with a tax deduction when you initially contribute (or, if it was an account that was funded by your employer, then they were the ones to receive the tax benefit). The money in this account is only taxed when you actually withdrawal from it.
So, over the years, the IRS has allowed you to invest this money with no taxes being paid but, at some point, you’ll need to start withdrawing money and pay tax.
Required Minimum Distributions, also called RMDs, are intended to make sure that taxpayers begin withdrawing a certain amount of money from their pre-tax accounts each year, once they reach a certain age. The theory here is that by requiring taxpayers to start withdrawing money, the government can start to receive tax revenue!
You are required to start taking RMDs when you reach a certain age, which I’ll review below. For the longest time, RMDs were required to begin once you reached age 70 1/2 but, as you’ll see, there have been a lot of changes with the rules surrounding RMDs over the last 4 years.
Here’s a brief rundown of the age you are required to start withdrawing money:
- Age 70 1/2 – If you were born prior to 6/30/1949
- Age 72 – If you were born between 7/1/1949 – 12/31/1950
- Age 73 – If you were born between 1951 – 1958
- 75 – Those born 1960 or later
The amount that you’re required to withdraw each year is based on your prior year-end account balance(s) (on IRAs and employer-sponsored retirement accounts) and a life expectancy factor based on your current age.
Essentially you’ll take your prior year-end balance and divide it by your life expectancy factor. You can find the current IRS life expectancy factors here (use Table III if you’re single or have a spouse that isn’t more than 10 years younger than you).
Planning Considerations
Those of you who have more significant pre-tax retirement account balances could face RMDs that result in a big increase in your tax liability. Once these RMDs begin we can’t turn them off (at least until all the money is withdrawn).
Fortunately, there are things we can do in the years prior to your RMD start date to help reduce that future tax burden.
Roth Conversions
One possible strategy is something called a Roth Conversion. Roth conversions are a process of rolling money over from a pre-tax account to a tax-free account (i.e. IRA to a Roth IRA). Money inside a Roth account does NOT have to be withdrawn and can continue to remain invested (growing tax-free!).
The catch here is that any money you convert to a Roth becomes taxable in the year it’s moved. This may not be such a bad deal though if your tax rate today is less than your future expected tax rate once RMDs begin.
Roth conversions put you in the driver’s seat and it let’s us control when taxes are paid.
An added bonus of completing Roth conversions is that any money that gets passed to your beneficiaries at death is potentially tax-free to them too! This can help to improve your after-tax estate.
Qualified Charitable Distributions (QCDs)
Yet another acronym (QCDs)! This is another excellent option to manage the tax burden of unwanted RMDs. If you’re charitably inclined and regularly give to charity then a QCD is a perfect option!
QCDs allow you to donate your RMDs to your favorite charities completely tax-free!
Essentially, a QCD allows you to make a direct transfer of up to $100,000 per year to your favorite charity. The amount treated as a QCD is completely excluded from your income; it is NOT a deduction so you don’t need to worry about meeting any sort of threshold in order to itemize deductions.
Here’s a quick example of how a QCD can work: Let’s say your first RMD at age 75 is $25,000. You have a couple options:
- Withdraw $25,000 and put it in your bank account; $25k is reported as income and is taxed at your marginal tax rate.
- Directly contribute the $25,000 to your favorite charity via a QCD.
If you use option 2 then the $25,000 is completely excluded from your tax return. This person could even make the decision to donate another $75,000 on top of the $25,000 RMD; all of this being tax-free.
Again, a QCD is NOT treated as a deduction. It’s simply excluded from your tax return. If it were treated as a deduction then you would have to donate enough to be able to itemize deductions on your tax return; today, very few people itemize.
Closing Thoughts
RMDs need to be considered when you’re developing your retirement plan in addition to each time you review and update your plan throughout retirement. A proper tax reduction plan should be developed well in advance of RMD age in order to be thoroughly prepared.
If you still have quite a few years before RMDs begin, start exploring ways to reduce that future ongoing tax liability. Many years of compounding growth can result in an ever increasing tax liability!
If you have any questions please don’t hesitate to reach out and be sure to subscribe to the monthly Next Adventure Financial retirement newsletter.
Welcome to the Next Adventure Financial blog where I share relevant info and educational content designed to help you have a comfortable retirement.
About the Author
Cody Lachner, CFP®, EA is a fee-only financial planner based in Lafayette, IN serving clients locally and virtually nationwide. Cody works with families approaching retirement and takes a tax-focused approach to retirement planning. His goal is to help families retire with confidence while lowering their lifetime tax bill.
