Commentary: How you can limit the bite of required minimum distributions
You may think that you have complete control over how you draw down your savings in retirement. In reality, Uncle Sam will have some input into just how much you may have to withdraw from your tax-deferred income sources every year. If you're con...
You may think that you have complete control over how you draw down your savings in retirement.
In reality, Uncle Sam will have some input into just how much you may have to withdraw from your tax-deferred income sources every year.
If you're contributing money to a tax-deferred IRA or 401(k), you benefit from years of tax-deferred growth on your contributions and earnings. There comes a time, though, when the government wants you to begin paying taxes on that money. Required minimum distributions (RMDs) kick in at age 70.5, and they require you to withdraw a certain percentage of your savings on an annual basis. The first year, the amount you have to withdraw is about 3.65 percent of your assets; that percentage increases each year as you get older.
The idea of RMDs can be scary for a lot of people. Not only is an element of your retirement income out of your control, but you may see a spike in your taxable income that you weren't accustomed to reporting on your tax return.
Fortunately, there are things you can do to limit the potential impact of RMDs on you in the years leading up to retirement.
Proactively Take Distributions
You can draw down your assets that are eligible for RMDs prior to age 70.5, although these distributions will be taxed. The question you may be asking yourself is, "Why would I want to pay that tax sooner than I have to?"
The advantage to taking these distributions at a younger age is that you can better ensure they don't push you into a higher tax bracket. We like to refer to this as "soaking up your tax bracket." By that, we mean maxing out the income you earn in your current tax bracket without moving into a higher tax bracket.
For example, let's say you and your spouse expect to earn $65,000 this year, putting you about $10,000 below the 25 percent tax bracket threshold. Soaking your bracket would involve taking $10,000 from your tax-deferred account this year, thereby ensuring the money is taxed at 15 percent. Waiting until RMDs to kick in could mean a portion of your income will be taxed at the 25 percent rate if a large portion of your savings is in tax-deferred vehicles.
Convert Tax-Deferred Dollars to a Roth
A twist on the idea of proactively taking distributions from your tax-deferred income sources is to convert that money to a Roth IRA. You will have to pay regular incomes taxes on converted dollars, but once that money is in a Roth, it will no longer be subject to RMD rules under current law. And for those who are receiving Social Security benefits, distributions from a Roth IRA aren't included in your provisional income when calculating the percentage of your benefits that may be taxable.
Roth conversions provide the additional benefit of allowing you to diversify the taxability of your retirement income. Often, people have an abundance of tax-deferred savings but relatively few tax-advantaged dollars. By making periodic Roth conversions, you'll increase the amount of tax-free money you'll be able to utilize in retirement.
There's likely little you can do to avoid paying taxes on your tax-deferred money entirely. That said, with a little bit of proactive planning, there are steps you can take today to better prevent an unnecessarily large tax bill in retirement due to RMDs.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of "Your Money" on KLKS 100.1 FM on Sunday mornings. Email Bruce and Peg at email@example.com . Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment adviser. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.