Three Ways to Cut the Tax Stress of RMDs

By Robert A. Guy, RICP, Kiplinger Consumer News Service (TNS)

Making tax-deductible contributions to your retirement accounts can seem like a luxury. However, they might become a burden in retirement if you don’t plan ahead.

If you’ve been saving in a 401(k) or other employer-sponsored retirement plan, a traditional IRA or other IRA-based plans, Uncle Sam will eventually come knocking for the tax revenue in the form of required minimum distributions (RMDs). An RMD is the minimum amount you must withdraw annually to avoid a tax penalty. The account owner is taxed at their income tax rate at the time of the withdrawal on the amount of the withdrawn RMD. The income from your RMD will be added to all your other taxable income to determine how much income tax you must pay for the year.

RMDs can hit you hard in retirement when you have to start withdrawing those funds annually, especially if you have a pension or other forms of taxable income that you already must consider when calculating your annual tax bill. The age at which you must start taking RMDs is 73, after Congress raised it in 2022 from 72. It will increase to age 75 in 2033.

Taking RMDs can:

Push you into a higher tax bracket.
Cause your Social Security to be taxed at a higher rate.
Result in increased Medicare premiums.
Increase net investment income surcharges.
Raise your alternative minimum taxes.

Managing your RMDs is the key to advanced tax planning and may save you significant taxes in retirement. Here are some strategies to help reduce or eliminate your RMDs:

1. Roth IRA conversion

Converting even a portion of your traditional IRA or retirement plan to a Roth IRA may offer significant financial advantages, partly because the money that is in a Roth IRA is not subject to RMDs. Any money you convert from a traditional 401(k), IRA, or 403(b) to a Roth IRA or Roth 401(k) is not subject to RMDs, and all of the growth on the account from the day of the conversion and all withdrawals from the Roth by you or your heirs will be completely tax-free. Withdrawals from a Roth IRA are tax-free as long as you are age 59½ or older and the account is at least five years old.

The rationale for doing a Roth conversion is that you want to pay the tax now (on the amount converted in a given year) rather than later in retirement when tax rates may be higher. Converting now allows you to take more control of your taxes. Wouldn’t you rather pay taxes at today’s known tax rates on the amount you convert, rather than pay taxes on larger account balances later in retirement at unknown future tax rates?

With advanced tax planning, you may be able to convert just enough of your traditional plans to Roth IRAs so that the new, lower RMDs won’t push you into a higher income tax bracket.

A key to understanding Roth conversions: valuing wealth in terms of purchasing power instead of total dollars.

When we think about money, we usually think in terms of having more dollars is better. Right? We all want our account balances to be as high as we can get them. I’m going to challenge that belief by suggesting to you that having “the most money” is not the best way to measure your affluence or wealth. I believe that the best way to measure wealth, or affluence, is by assessing your total purchasing power, not your total dollars.

Let’s say you have $1 million in a traditional IRA. Even though you have that amount in dollars, you do not have $1 million in purchasing power. This is because the money in the traditional IRA or 401(k) is tax-deferred, not tax-free, and you will have to pay income tax when you take money from that IRA.

So, even though the total dollar amount of your IRA is $1 million, you may have far less than $1 million available to you to spend and enjoy. You have a big fat IOU to the IRS on that IRA that must be paid before you can reap the benefits from that account. Understanding the concept of purchasing power is crucial to truly understanding the benefits of a Roth IRA conversion.

2. Qualifying longevity annuity contract (QLAC)

In July 2014, the Treasury Department relaxed the RMD rules, reflecting the government’s desire to encourage individuals to prepare financially for retirement. The new rules allow you to buy a longevity annuity with your IRA money and not have to worry about including the value of that IRA qualifying longevity annuity contract (QLAC) in your RMD calculations from age 73 up to 85.

Tax-deferred plans are exempt from RMD rules as long as the plan participant does not use more than $200,000 to buy the longevity annuity. For a couple, that means up to $400,000 could be placed into QLACs, removing that money from the RMD calculations. The couple can then defer RMDs on that $400,000 up until age 85. Removing the $400,000 from the RMD calculation until age 85 could result in substantially less RMD payments during that time, while also providing an additional source of income later in life.

An important thing to know about QLACs is that they are available within 401(k), 403(b), governmental 457, 401(a), and individual retirement accounts. Roth IRA accounts are not eligible, nor are inherited IRAs or accounts already in RMD status. It is also important to note that the decision to purchase a QLAC is irrevocable, and the annuity generally cannot be surrendered for its cash value.

3. Charitable lifetime planning with IRAs

Frequently, my clients take RMDs from IRAs not because they need them but because they are required to take them. Sometimes, they deposit the money in their bank account and then write a check to their favorite charity or religious institution. Another option is for them to take advantage of a qualified charitable distribution (QCD), which works particularly well for high-income earners. It allows IRA owners to specify that a payment of up to $100,000 from their RMD be sent directly to a qualified charity.

The owner electing the QCD option is still required to take the RMD, but the amount of the distribution sent directly to the charity gets excluded from their gross income. This provision gives taxpayers a convenient and tax-savvy way to benefit a charity, while also saving themselves potentially thousands of dollars in taxes. The charitable deduction for the direct IRA donation may be 100% tax-deductible for most taxpayers.

This is especially effective for high-income taxpayers who at tax time are subject to adjusted gross income limitations as well as phaseouts of their itemized deductions.

Donating IRA distributions directly to charity may minimize the amount of taxable Social Security benefits because you are excluding that money from your income. A lower income may also help you lower your Medicare premium. Also, the charitable IRA rollover provision gives non-itemizers a way to deduct their charitable contributions.

Converting your RMD to a direct donation can make a lot of sense, but there is an additional benefit that most people, including financial advisers, rarely think about. A donation of this type frequently results in substantial income tax savings—so why not take advantage of those savings and convert part of your traditional IRA to a Roth?

Investment advisory services offered by duly registered individuals through Creative One Wealth, LLC, a Registered Investment Adviser. Creative One Wealth, LLC and Tax & Investment Advisor are unaffiliated companies. Mr. Guy is a licensed insurance professional, not affiliated with any government agency, and does not provide tax or legal advice. You should consult with your own legal and tax professional before implementing any of the ideas in this article.

Converting an employer plan to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences including (but not limited to) a need for additional tax withholding or estimated tax payments, the loss of certain deductions and credits, and higher taxes on Social Security benefits and higher Medicare premiums in the year of conversion. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA.

Dan Dunkin contributed to this article.

ABOUT THE AUTHOR:

Robert A. Guy, RICP, is president of Tax & Investment Advisors, a retirement planning firm located in Newburyport, MA.

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