There’s a plethora of tax advantaged retirement accounts out there today. Enough that the acronyms and numbers can get really confusing…
- Profit sharing
- SEP IRA
- SIMPLE IRA
Just to name a few – trust me, there are more. The reason? The government wants us to save for our own retirement. And by offering an array of tax advantaged accounts, they’re incentivizing us to put money away.
But while the tax advantages are great, the government won’t let us shelter our money from taxes forever. When you turn 70 1/2, they’ll force you start taking withdrawals called required minimum distributions, or RMDs. If you don’t you’ll be subject to a hefty 50% penalty.
This poses quite a problem for many retirees, since each withdrawal raises their tax liability for the year. So for those of you who want to keep Uncle Sam’s grimy mitts off of your hard earned retirement funds, here are six ways to minimize your RMDs:
1) Convert a Traditional IRA to a Roth IRA
You’ve probably run across this option before. If your retirement assets are in an IRA, you can convert them to a Roth IRA. Since Roth IRAs are tax exempt (you pay tax on contributions, not withdrawals), they don’t impose required minimum distributions once you turn 70 1/2.
If your retirement dollars are in an employer’s 401k plan, you might also have the option to convert them to Roth 401k balances. This type of conversion is legal but not all plans allow it, so you’ll need to verify that it’s an option.
In either scenario, if your account contributions were made with pretax dollars, you’ll owe income tax on the amount you convert.
This strategy works best if you have a few years where your income drops. Since the conversion will trigger an income tax liability, you can take advantage of a lower tax bracket. The trade off is that you’d pay less tax voluntarily than you would if you waited for RMDs to force your hand.
2) Contribute to a Roth 401k While Working
Roth 401k options are becoming more commonplace these days. If you have access to one, think hard about using it. You’ll pay income tax on the contributions of course, but just like a Roth IRA your withdrawals will be tax free.
This brings up another important point – tax diversification. If you have the opportunity, it’s extremely helpful to have a portion of your retirement accounts in tax deferred accounts (like 401k, 403b, or IRAs) and a portion in tax exempt accounts (Roth 401ks or Roth IRAs).
When it does come time to take withdrawals in retirement, you’ll have two options:
- Withdraw from a tax deferred account, triggering taxable income
- Withdraw from a tax exempt account, which comes out tax free
This idea is known as tax diversification. When combined with some tax planning, it can save you a boatload on taxes throughout retirement.
Think about it: if you have the choice you can space out your taxable withdrawals in the years you have less income, and take advantage of the lower brackets. In the years your income is up and you’re in a higher bracket, you can pull from the tax exempt account.
I should note though that the IRS does make you take RMDs from Roth 401k accounts. They can easily be avoided though, by rolling over your balance into a Roth IRA once you retire. You’re not required to take RMDs while you’re still working.
3) Reverse IRA Rollovers
If you’re still working at age 70 1/2, you can actually roll money from your IRA to your company’s 401k plan free of penalty, as long as your IRA was funded with pretax dollars. Since you’re allowed to delay RMDs from your employer’s 401k plan as long as you’re still working there, this is a nifty way to postpone the withdrawals.
One caveat is that every 401k plan is slightly different, and you’ll need to check to make sure your plan allows such transfers. This is likely not a problem though, since 70% of all plans do according to the Profit Sharing Council.
In addition to delaying your RMDs until you retire, you might also have the opportunity to convert the balances into Roth 401k funds. Again, your plan must allow such conversions. You’ll also owe income tax on the conversion, which might kick you into a higher bracket. Even so, it’s a good idea in some circumstances since you’ll likely have more cash flow to pay the taxes while you’re still working.
4) Buy a Qualified Longevity Annuity Contract
The IRS passed legislation in 2014 that allows you to postpone RMDs if you buy a QLAC. Whereas an immediate annuity gives you monthly income beginning at the time of purchase, a longevity annuity starts payments at a later date. It’s used as a hedge against the possibility that you live beyond your life expectancy. In order to qualify as a longevity annuity, the contract must have a few features:
- It must begin distributions no later than the first day of the month after you turn 85.
- It may not include a variable, indexed, or similar growth feature.
- There can be no cash surrender value.
The rule allows you to postpone RMDs up until the date of annuitization, which must occur by the time you turn 85. This means that by employing the strategy you can postpone RMDs nearly 15 years.
There are limitations, though. The amount excluded from the annual RMD calculation is limited to $125,000, or 25% of your retirement account balances.
5) Qualified Charitable Contributions
Giving to charity doesn’t necessarily reduce your required minimum distributions, but it does reduce your tax liability from the RMD.
A qualified charitable contribution allows your RMD to be paid directly to a qualified charity, meaning that you won’t owe any tax on the withdrawal. The exclusion applies to IRAs only though – not 401k or other qualified retirement plans. It’s also limited to $100,000.
The amount of your donation will be excluded from adjusted gross income, so you won’t be eligible for a charitable deduction too. There are a few other rules too, so if you’re considering this it would be wise to consult with a CPA.
6) Begin Distributions Before 70 1/2
Another way to reduce required minimum distributions? Start distributing from the account before you’re required to. This might seem like a cop-out answer, but if done strategically it can reduce your tax liability.
This is where you’ll need to incorporate some long term tax planning. After you turn 59 1/2 and can take withdrawals from the account free of penalties, try to get a feel for what your income might look like over the next 11 years.
If there are any years where your income dips significantly, it might be a good idea to take a withdrawal. This strategy let’s you take advantage of a lower tax bracket, and work down your account before you’re required to take withdrawals at 70 1/2.