Well you knew the government was going to get their fair share eventually. For pre-tax retirement assets, it just so happens that time is when you turn 70 ½. By the way, I have no idea why the IRS decided that you can take penalty free withdrawals at age 59 ½ and Required Minimum Distributions (RMDs) start at age 70 ½. Was it just too easy to have these start at a full age? Trying to keep us financial planners in business with complicated rules? None the less, you have been able to contribute and grow your 401(k) and IRAs tax deferred until you hit 70 ½, and now you need to start taking distributions and pay the tax man. This post discusses different withdrawal strategies for your RMDs.
First, a couple basics regarding required minimum distributions (RMDs):
- Your first RMD is required the year in which you turn age 70 ½
- If you are still working at age 70 ½ you can defer taking RMDs from your current 401(k) plan
- That first year, you are required to withdraw roughly 3.65% of the account value
- As you get older, you are required to take a higher percentage out each year
- RMDs are required on pre-tax IRAs, 401(k)s, 403(b)s, etc.
- RMDs are not required on Roth IRAs
Now, you have to decide what you will do with the RMD. I offer a few suggestions below.
You know that European river cruise that you have been delaying because you didn’t want to spend the money? How about that kitchen remodel that you keep putting off, or upgrading the bathroom? Well, you’re not getting any younger and like it or not, you have some money coming your way. Yes, this money was yours to begin with, but now you are forced to make a decision. Remember, the RMD for your first few years is less than 4%, which is a very low withdrawal rate. You absolutely should feel comfortable taking this small distribution and not be worried about exhausting all of your money before you pass. You worked hard to save your money, and I can understand wanting to make sure you don’t run out of money. You also saved your money so that you could enjoy retirement and try new things. If you haven’t already, this is the perfect time to start spending your money.
Just because you have to take distributions out of your IRA, it doesn’t mean that the money has to stop growing. You can withdraw the funds from your pre-tax assets, pay the taxes, and move the money to a taxable brokerage account. This allows you to continue to invest, and hopefully grow your money. If you do decide to continue to invest your RMDs, typically you are better off waiting until near the end of the year to take the distribution. The funds just need to be withdrawn from your IRA prior to the end of the year, and waiting until the end of the year has a tax advantage. If the stock market goes up, you are withdrawing the funds later in the year while the account is growing tax deferred. If withdrawn at the beginning of the year and invested in a brokerage account, you would now be on the hook for the taxable gain for that year.
If you are charitably inclined, RMDs offer an excellent opportunity to gift assets while saving you on taxes. When you turn age 70 ½ you can donate your RMD to a charity and the funds pass on to the charity free from any taxation to you. Nervous that RMDs are going to shoot you into a higher tax bracket? Take advantage of the Qualified Charitable Distribution (QCD) and pass those funds to your charity of choice. There are a few rules for passing these funds, tax free, to your favorite charity.
- You must be age 70 ½ or older (not just the year in which you turn 70 ½)
- The maximum amount is $100,000 per taxpayer per year
- Must come from an IRA (not SEP, Simple, or 401(k) plan)
- Distribution must go to a public charity and check must be paid directly to the charity
A charity isn’t the only place that you can gift your assets. There is a good chance that if you aren’t spending your RMD, you will be leaving a large inheritance to your heirs. Sure, your kids and grandkids would appreciate a nice inheritance when you pass, but wouldn’t you rather gift these funds to them when you are living. No, there is no tax benefit of gifting your RMD to your family. You still pay taxes on the distribution, but as long as you limit your gift so that it doesn’t exceed the yearly gift exclusion, you won’t pay any gift taxes. You may find more gratification helping the grandkids save for school or bringing the family on a nice vacation while you are living as opposed to leaving the funds once you pass.
Converting assets is not necessarily an RMD withdrawal strategy, rather a strategy to avoid future RMDs. Once you hit age 70 ½, converting funds from an IRA to a Roth account is probably too late, as the goal of a Roth conversion is to avoid the RMDs in the first place. Typically, Roth conversion planning starts well before you reach age 70 ½. For our clients who are considering a Roth conversion strategy we start the conversions as soon as they are retired, once their income and tax liability decreases. A Roth conversion strategy involves converting pre-tax assets to Roth assets with one of the goals to avoid future RMDs. As noted previously, there are no RMD requirements for Roth IRAs. A Roth conversion involves converting and paying taxes now, to avoid paying taxes on distributions in the future. Starting early is key because converting small amounts each year helps reduce the tax liability. Converting a large amount all at once could result in a significant tax bill. A Roth conversion strategy is typically most appropriate for people who want to leave a sizeable estate while reducing their long-term tax liability.
I spoke with a client recently who was 67 and looking forward to RMDs because he was going to take his dream African safari. He currently wasn’t taking any money out of his savings and as soon as he is forced to take the money out, he would finally pay for the safari. I told him that is a great idea, absolutely you should spend your RMD on a trip to Africa. But why wait? Sure the RMD forces you to take money out of your retirement accounts, but this doesn’t mean you have to wait until 70 ½ to start spending your retirement savings. I’ve outlined some RMD strategies above, but at the end of the day remember why you saved this money in the first place. Yes, we want to make sure the money lasts until you pass. We also want to make sure you enjoy retirement. Don’t be afraid to spend your RMD, and remember you don’t have to wait until 70 ½ to start taking those dream vacations.