Many high earners want to know what strategies they can implement to help reduce the tax burden caused from large, unwanted required minimum distributions (RMDs) in retirement. In Part 6 of a 7-part series, “Tax Saving Strategies for High Earners,” we break down what you need to know about RMDs and explain the strategies to maximize your savings today without causing excessive taxes from RMDs later.
At BWM, we’ll evaluate the following strategies below to help reduce your RMDs and effectively lower your tax bill in retirement. It starts with creating a savings strategy today that will lower your RMDs later. If you’re retired, we’ll evaluate if it makes sense to take IRA distributions now or convert pre-tax IRA money to tax-free Roth investments. You can also reduce your RMDs without paying taxes by making a Qualified Charitable Distribution. It’s also a good idea to make sure the investment fees for your IRA aren’t being paid out of another account.
A required minimum distribution (RMD) is the amount of money you must withdraw from certain retirement accounts each year once you turn age 72. RMDs generally apply to tax-deferred retirement savings. Contributions to these accounts are made with pre-tax dollars, and RMDs ensure that the government will ultimately receive the taxes due on these amounts.
You must pay ordinary income taxes on these withdrawals and if you fail to take your full RMD by the appropriate deadline, you may have to pay a 50% penalty tax on the difference between your RMD and the amount you withdrew.
Roth IRAs are generally exempt from RMDs because contributions are made with after-tax dollars. The IRS states you must take RMDs from the following accounts:
The amount of money you must take from your IRA each year is based on your age and the year-end balance of your account The IRS calculates your RMD by dividing the prior December 31st balance of your IRA by a life expectancy factor which can be found on the Required Minimum Distribution Worksheet published by the IRS. Generally, this means your RMDs will increase as you get older.
Once the specific RMD for each IRA has been calculated, you can total the sum of these RMDs and take them from any one or more of your IRAs. For example, imagine you have two IRAs each with a $50k RMD. Rather than withdrawing $50k from each IRA, you can simply take $100k from one IRA, and not withdraw any money from the other. This can be especially helpful if one of your IRAs holds an investment that is illiquid and can’t quickly be converted to cash.
RMDs are generally taxed at your ordinary income tax rate. There’s one exception to this general rule. You will not be taxed for any portion of an RMD that is a return of a non-deductible contribution. In other words, if you did not receive a tax-deduction in the year you contributed to your IRA because your income was too high, then you will not owe taxes on the portion of your RMD that is considered a return of your non-deductible contribution. However, you must file Form 8606 with the IRS in the year in which you make an after-contribution, and there are filing rules that must be followed to avoid double-taxation.
While making non-deductible IRA contributions may reduce your RMDs, it’s generally not a smart strategy. You won’t get a tax deduction for putting money in, the money you invest won’t grow tax-free, and you’ll have to calculate the portion of your RMD that is considered a return of your non-deductible contribution and shouldn’t be taxed. For these reasons, there are typically much better ways to save for retirement.
You are subject to RMDs beginning in the year you turn age 72. You may delay taking your first RMD until April 1st of the year following the year you turn 72. But for each subsequent year, you must take your RMD by December 31st. So, if you turn 72 in June of 2022, you have until April 1stth of 2023 to take your RMD for 2022. But your RMD for 2023 must be taken by December 31st of 2023.
This means if you were to wait until April 1st to take your 2022 RMD, then both your 2022 and 2023 RMDs would be reported as income on your 2023 tax return. Doubling your RMDs in one tax year can create a higher tax bill and may cause some of your income to be taxed at a higher rate. For this reason, to smooth out your tax bill it’s generally better to take your first RMD by December 31st of the year you turn 72.
No, if you withdraw more than your RMD amount in one year you can’t apply your excess distribution towards your RMD for future years. In other words, you can’t take future years’ RMDs in the current year. For example, while it may be a tempting strategy to take next year’s RMD this year if you’re in a low tax bracket, IRS rules do not permit this.
No, the IRS does not allow for RMDs to be rolled over into other retirement accounts, including a Roth IRA. That means you cannot simply take RMDs out of your IRA and reinvest the funds in another IRA. This leaves you with two options. You can either spend your RMD, or you can reinvest it in a non-retirement account like a trust.
The wrong savings strategy can lead to inconvenient and unavoidable tax consequences in retirement. Making decisions about how much to save, what accounts to save into, and how to invest your savings can be a complex and challenging process to handle on your own.
At BWM, we’ll review your full financial picture to help you create a savings strategy that’s best for your specific needs. If it’s projected that you’ll be subject to higher taxes in retirement because of unnecessary RMDs, we’ll help you implement tax-deduction strategies to lower your future RMDs and create a more tax-efficient income stream in retirement.
Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.