RMDs: What Are They and How to Limit Them

If you’re saving money in a 401(k) or traditional IRA for your retirement, you probably know your taxes are perennially deferred on these accounts—likely over many decades. Unfortunately, the government will inevitably look to collect its fair share of taxes at one point or another. For many retirees, this time will arrive when required minimum distributions (RMDs) eventually hit their plans.

How required minimum distributions work

Simply put, RMDs are the minimum amount of money one must withdraw from specific tax-deferred retirement accounts beginning at age 73 (as of January 1, 2023). Starting in 2033, this stipulation will climb to age 75.

More specifically, RMD rules apply to various employer-sponsored retirement plans including 401(k), 403(b), profit sharing, and 457(b) plans. The mandate also applies to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs, as well as Roth IRAs (following the owner’s death).

Those impacted are required to take their RMDs by December 31 of each year. However, a couple of options are available with respect to taking your very first RMD. For example, if you turn 73 in 2023, you can either do so by either December 31, 2023 or April 1, 2024. Just know that no matter which option you choose, you’ll need to take your second RMD by December 31, 2024.

RMD penalties

If your circumstances dictate you withdraw more than the minimum amount required, you can! However, keep in mind that this may involve tax implications as your withdrawal will be taxed as ordinary income (i.e., the same rate as any wages, interest income, or short-term capital gains).

Alternatively, if you fail to take the full amount of your RMD by the required deadline, you may face a hefty penalty and be liable for a 25% tax on the amount not withdrawn. Note that this penalty can be reduced even further (to 10%) if you correct it in a timely fashion by withdrawing the required amount and submitting an updated tax return on time. Furthermore, you can seek out help from the IRS in an attempt to waive this penalty, but you’ll need a good reason such as a serious illness or assertion that you received lousy advice from a tax preparer or IRA sponsor.

How to calculate required minimum distributions

You can generally divide the balance of your retirement plan (as of December 31st of the previous year) by a life expectancy factor to calculate your RMD. Feel free to refer to this IRS worksheet or use this calculator to do so.

Required minimum distribution strategies

For many retirees, RMDs aren’t a big deal as they rely on that money for various expenses. However, others who live off other sources of income during retirement may not need these funds right away; it’s therefore not so unusual for this segment to seek out RMD avoidance or reduction strategies. Here are some common examples of this:

Remain employed

The “still-working” exception allows you to delay RMD requirements for your employer-sponsored retirement account, provided you meet the following conditions: you’re still working (perhaps that’s obvious, given the name), own less than 5% of the company you work for, and have an employer-sponsored retirement account from your current employer. To be clear, “still-working” means you are employed—regardless of how many hours you work per week.

The primary benefit of a still-working exception is that it allows you to postpone an RMD until April 1st of the year following separation of service. Keep in mind that this exception only applies to accounts with your current employer rather than companies you no longer work for.

Convert to a Roth IRA

Another strategy to avoid RMDs is to roll over some of your savings into a Roth IRA, which doesn’t include any RMD mandates over the span of your lifetime. This means any earnings in a Roth IRA can grow tax-free for as long as you’d like!

The biggest drawback with this option is the need to pay taxes on the amount of money you convert, as you’re moving pre-tax money. Consequently, conversions are sometimes expensive.

Employ a carve-out strategy

Two types of carveout strategies are available. The first one—known as a “qualified longevity contract” (or QLAC)—allows you to invest (or carve-out) up to $200,000 into a special type of deferred income annuity. This number is adjusted annually for inflation. As a result of this strategy, money invested in the QLAC is dropped from the IRA balance and therefore not subject to RMD mandates.

The second type of carve-out applies to company stock you may own in your 401(k) and is known as a “net unrealized appreciation strategy.” With this option, you roll over the portion of your 401(k) invested in company stock into a taxable account—such as a brokerage account—and the remaining balance into a traditional IRA. The corresponding benefit is that you’ll ultimately pay taxes on company stock on a cost basis (original value of the stock) rather than its market value. Moreover, any additional value gained after the stock is initially purchased is taxed as capital gains and not ordinary income: thus potentially saving you money. Employing this strategy will leave less money in your retirement account, in turn lowering your RMD dollar amount.

Donate distributions to a qualified charity

This strategy—also known as the “qualified charitable distribution (QCD) rule”—provides a few opportunities for owners, including the option to transfer up to $100,000 from a traditional IRA account to an IRS-qualified charity every year rather than pay taxes to the government. (Please note this amount can vary annually as it is indexed for inflation.) The benefit? You are allowed to exclude the QCD from your taxable income.

Execute an in-kind transfer

With an in-kind transfer, you make an RMD distribution from your retirement account in the form of investments rather than receiving cash. This essentially means you can move your stock/investment from your tax-advantaged account into a taxable investment account—such as a brokerage account—without the need to liquidate shares.

While in-kind transfers are taxable, this strategy is sometimes useful when markets are down—given that you’re paying income tax on securities of relatively low value and only paying capital gains rates on the future growth of those securities.

Limit distributions in the first year

You can take your initial RMD by December 31st the year after you turn 73 or—as we mentioned earlier—wait until April of the subsequent year (2025, if your 73rd birthday falls within 2023). Should you decide to wait, in this example, your second distribution would be due by December 31, 2025.

Taking two distributions in the same year can push some investors into a higher tax bracket and thus require a larger payment to Uncle Sam. For others, it may make more sense to take their first distribution as soon as possible to limit their tax liability.

In sum: required minimum distributions

Whether retirement is on the horizon or still a few years away, it’s obvious that related preparations involve so many unique circumstances: including understanding RMDs and corresponding strategies. Fortunately, you don’t need to go it alone and can seek out help from a trusted financial advisor as you set out to navigate the path toward retirement.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice.  We suggest that you discuss your specific tax issues with a qualified tax advisor.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.

In addition, if you are required to take required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.