How "Required" Are Required Minimum Distributions (RMD) From Your IRA?
- Lyman D. Howard, CFA CFP®, Portfolio Manager
Clients are frequently surprised to learn that the IRS requires investors over the age of 70.5 to begin distributing portions of their Traditional Individual Retirement Accounts (IRA) or 401k/403b defined contribution accounts, regardless of whether they need the money to live on during their retirement. The frustration is that IRA distributions are treated as ordinary income, so the higher the investor’s marginal income tax bracket, the greater the tax bite. That extra income even has the potential to boost the client into a next higher bracket. So, you might be asking, is there some way to avoid this dilemma?
- 401k/403(b) plan features – If you are over 70.5 but still working full time, you will likely be able to postpone annual RMD until after you’ve actually retired, but only in your employer based defined contribution accounts, NOT your IRAs.
- Charitable giving – Not yet renewed by Congress for 2015, an individual can distribute up to $100,000 RMD directly from the IRA to a qualified charity and it will satisfy the distribution requirement and be free from income tax. For 2014 Congress only approved this at the eleventh hour. Do check with your tax professional before making decisions about taking such action.
- Use Roth Accounts – With a Roth you pay your income taxes on the front end, and there is no income tax liability on future qualified withdrawals. As a result, the IRS doesn’t need to force distributions in retirement to collect income tax. The Result: No RMD
Prepare for your RMD
With the exception of the year you reach 70.5, you must distribute RMD from your retirement account by December 31 of each year afterward, so plan for it. There is a substantial penalty for failing to take RMD (50% of the amount you fail to distribute to yourself!)
- Calculate the mandated amount (your CPA or wealth manager can assist)
- Consider owning investments that mature just in time to produce needed cash, so that you don’t have to sell securities on short notice
- Decide whether or not to withhold income taxes on the distributed amount, and if withholding is mandatory at your brokerage firm, then consider delaying your distribution until late in the year
- Consolidate accounts to make the logistics easier, since one IRA account can serve as RMD source for all IRAs, a single 401k can serve as source for all 401k, et cetera
- Manage your other income sources to account for RMD income, which you can expect to increase every year based on life expectancy tables
Utilizing Roth Accounts
Roth IRAs – These allow for annual contributions of $5,500 ($6,500 for those over 50 years old) during your working years, but they are disallowed if you’re income is too high. You can deposit your annual contribution as late as April 15th of the following tax year, allowing your CPA/tax preparer to fully determine your eligibility before the deadline.
Roth 401k - If your company offers a 401k plan, it might also offer a Roth version. If so, you can fund it annually with after-tax employee contributions up to the annual limit. Once you leave the company that Roth 401k balance can be rolled into a Roth IRA, avoiding future RMD.
Conversion - In any given year you can convert a Traditional IRA into a Roth IRA by paying income tax on the conversion amount. It can be done in whole or in part with no upper dollar limit. Your tax professional can guide you to an optimal amount.
“Back Door” Roth IRA- This one is a bit more complex, and involves making an after-tax contribution to your Traditional IRA, then immediately converting that after-tax amount to a Roth IRA, thus skirting the income phase out mentioned above. There are multiple caveats and complexities associated with this tactic, so consult a tax professional before you try it.