Uncle Sam is Coming For Your IRA

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One of the advantages of 401(k)s and traditional IRAs is tax deferral.

Whatever amount you contribute today lowers your taxable income for the year and you don’t pay any taxes on that money until you withdraw it.

But this perk only lasts so long…

When you reach age 70 ½, Uncle Sam comes calling for his cut, and how the government takes its share is through something called Required Minimum Distributions (RMDs).

The idea is that the government wants to collect taxes for all that tax-deferred growth and the original tax-deferral you’ve benefited from but it’s willing to wait until you’re in a lower tax bracket in retirement.

However that last piece is not always the case. RMDs are meant to help supplement a retiree’s income. But some retirees don’t need the extra cash flow from RMDs and would rather minimize them and the resulting tax bill.

If you’re close to age 70 ½ and you don’t plan on using RMDs to cover your living costs, here are four ways you can limit or even eliminate RMDs altogether:

Take Your First Distribution ASAP

A big reason why RMDs get such a bad rap is that the amount you’re required to draw down can sometimes push you into a higher tax bracket, which means you end up giving away more of your hard-earned cash to Uncle Sam.

When you turn 70 ½, you have until April 1 of the following calendar year to take your first distribution. After that you must take it by December 31 on an annual basis.

A mistake I see a lot of retirees make is they opt to hold off taking their first RMD because they figure it doesn’t really matter since they’ll be in a lower tax bracket regardless.

While holding off makes sense for some people, it also means you have to take two distributions in one year, which can bump you back into a higher tax bracket.

A better strategy is to take your first distribution as soon as you turn 70 ½ to avoid having to draw down twice in the first year.

Convert to a Roth IRA

Another strategy I recommend is converting all or part of your traditional IRA to a Roth IRA. Unlike traditional IRAs or Roth 401(k)s, which require RMDs, a Roth IRA doesn’t require any distributions at all.

This means your money can stay in the Roth IRA for as long as you want or it can be passed down to heirs.

When you convert part of a traditional IRA account, you’re reducing the amount subject to RMDs later on. This strategy requires some planning and you’ll need to still navigate taxes due on the amount converted.

But you can maximize this strategy by converting during years when your income is lower than usual. Typically during your first few years of retirement,

Don’t Stop Working

As mentioned above, the reason for RMDs is that the IRS wants to get paid for previously untaxed income. If you’re still working and you don’t own 5% or more of the company you work for, you can delay distributions when you turn 70 ½.

This exemption only applies to your 401(k) at the company you currently work at. If you have money stashed away in an IRA or 401(k) from a previous employer, you’re still on the hook for those RMDs.

What happens if you don’t take your RMD?

If you forget to take your RMD or miscalculate how much you owe, you’ll be subject to an excess accumulation penalty, which is 50% of the required distribution.

For example, if your RMD is $3,000 and you don’t take it, you’ll have to pay an additional $1,500.

Give It Away to Charity

This last strategy won’t reduce your RMD, but it will lower your tax liability from the RMD you owe. You’re allowed to donate part of your RMD, up to $100,000, directly to a qualified charity.

The donation is not included as part of your income and you’re also not eligible for a charity deduction on top of this. But the benefit of this strategy is it can significantly lower your adjusted gross income.

Qualified charitable distributions apply only to IRAs and not traditional 401(k) accounts.

Final Word

A lot of retirees rely on RMDs to cover their basic living costs. If you’re one of the lucky ones who don’t need the money, consider implementing some of these strategies to limit the amount of tax you owe from RMDs.

Working longer, converting to a Roth IRA, taking distributions early, and donating to qualified charities are all solid strategies to keep what’s rightfully yours.

To a richer life,

Nilus Mattive

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