If you’re serious about saving and you contribute the maximum to a tax-deferred retirement account such as a 401(k) or IRA, you should be commended.
Eventually, however, you’ll retire and those Required Minimum Distributions (RMDs) will come calling.
It’s our philosophy that it’s best to prepare for them in advance.
RMDs are the minimum amounts of money you must legally start withdrawing from your tax-deferred retirement account(s) the year after you reach age 70½.
The exact amount of your RMD is based on an IRS formula.
So far, so good?
But, if you’re thinking it’s all straightforward from there, and that there’s really no way to make RMDs work for you, or that they’re even something you can ignore, you need to reconsider.
The fact is, when it comes to RMDs, there are lots of things to understand. And these are things that could either save you money or cause you headaches down the line.
RMD considerations? Here are three.
The rules governing RMDs are serious
One sure-fire way to make certain you save on your RMDs is by closely understanding and following the rules.
Because, when it comes to RMDs, even if you make an innocent mistake, you’ll pay for it.
The IRS mandates that you must take your first RMD by April 1st the year after you turn 70½ (in other words, if you turn 70½ on December 1st, 2019, you need to take your first RMD by April 1st, 2020).
And, after your first year taking RMDs, you’ll need to take them by December 31st each year after that.
Understandably, you might be wondering if these dates are guidelines or rules?
They are not only rules, mistakes are punishable by a whopping 50% penalty.
Here's an example: let’s say you wait to take your 2020 RMD until 2021.
Because you were late, you’ll have to pay the equivalent of 50% of the amount you failed to withdraw as a penalty. That means, if you’re supposed to withdraw $30,000 in 2020, but you put it off until 2021?
You’ll get hit with a $15,000 fine.
Now, while we’re not encouraging you to ever mess with the IRS, if for some valid reason you fail to take your RMD, say, you were stranded on an ice breaker near the South Pole, you can request a waiver, but the conditions under which these waivers are approved are difficult to predict.
Save on taxes by donating your RMD to charity
In this instance, let’s say you have a good-sized balance in your IRA, and, over the years, rather than withdraw any of the money, because it’s incubating tax-deferred, you’ve let it grow and grow and grow.
Now, you turn 70½, so you’re going to need to start taking RMDs. Yet, because you’ve used other monies to fund your retirement, your retirement account has accrued to a point where now the IRS says you’re going to have to take a very large withdrawal; a big chunk of which is going to get gobbled up by taxes.
What can you do?
Think charitable giving. (But not in the traditional, “itemized deduction” sense.)
You and your spouse can each give up to $100,000 from your IRA to an approved public charity.
This has the multi-pronged benefit of helping you to meet your RMD obligation(s) while simultaneously not having to count the withdrawal(s) as income. You’ll not only likely lower the amount of income tax you’ll owe, but it will also enable you to meet (or help meet) your RMD requirement(s), all while boosting a trusted charity in the process.
Some 401(k) plans let you delay taking your RMDs
It’s called an “RMD reprieve,” and it can pay off for people who keep working, who keep contributing to their retirement account, and whose plan allows it.
Among other restrictions, you must own less than 5% of the company that hosts your plan.
The beauty of an RMD reprieve is that it allows for late starters - and people who perhaps just don’t want to retire - to accumulate more savings. If available to you, in simplest terms, if you work even one day into a new calendar year, a reprieve means you can push off the start of RMDs until April 1st of the following calendar year.
The importance of planning ahead
Tax-deferred retirement accounts are a great way to build wealth, and RMDs are simply the government’s way of making certain they get their share.
Because, in their eyes, they’ve been patiently waiting for the tax revenue from your savings for years.
One issue we see is when newer retirees only tap their other savings or investments for income and just let their tax-deferred accounts continue to grow, right up until age 70½, when they’re forced to take RMDs.
This can become a problem (as referenced above) when a retirement account grows so large that the RMDs bump you into a higher tax bracket.
We’ve seen this needlessly cost people thousands, even tens of thousands of dollars extra, just in taxes.
Like an investment strategy, distribution strategies take expertise and foresight.
When it comes to holding on to your hard-earned wealth, once you retire, choosing the accounts you should derive your income from, and in what order, is an art form that takes education and planning.