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Don't Be Caught by Surprise by Required Minimum Distributions

Couple meeting with Advisor

During your working years, the focus is on accumulating the assets that will help fund your retirement – which can include a traditional (defined benefit) pension, defined contribution plans such as 401(k)s or 403(b)s to which you've been contributing, traditional or Roth individual retirement accounts (IRAs), stock and other investments, and personal savings.

So much emphasis is placed on reaching "the number" – that is, the total amount of assets you want to have amassed by the time you are ready to retire – that many people have not thought about how they'll access those funds in retirement.

One critical time period to understand is the five-plus-year period between the traditional retirement age of 65 and age 70-1/2, when retirement plans' required minimum distributions begin. For many people who have saved early and diligently, the bulk of their assets may be in tax-advantaged retirement accounts, and the actions you take between your retirement and age 70-1/2 can greatly affect your future finances.


Preparing for RMDs and for Social Security

While you may be aware of the "required minimum distributions," or RMDs, that accompany retirement plans and traditional IRAs, do you really understand how they work, and how your withdrawal decisions – and timing – can affect both your income and your taxes?

When a person has conscientiously saved for retirement, it's easy to think they're all set. "But their work isn't done," says CPA and financial advisor Sheryl Rowling, based in San Diego. "The first thing they can do, even though they're still years away, is take a look at the IRS's RMD tables."

The RMD is the amount retirement plan holders have to withdraw each year, once they pass age 70-1/2. Since the money that went into the IRA or 401(k) was not taxed, nor were any of the investment gains, the IRS is now about to get its share, as these withdrawals are fully taxable. The amount that has to be withdrawn is based on actuarial tables, with the percentage of the balance increasing year by year.

Rowling suggests a next step: "They should also be aware of their Social Security benefits." Here is another possible surprise: Since RMD income is completely taxable at a rate equivalent to wages, depending on the amount of the RMD and based on current tax policy, up to 85 percent of your Social Security income may be fully taxable as well.


Devising a Withdrawal Strategy

Without understanding the implications of their choices, retirees could be making a big financial mistake to basically coast between the ages of 65 and 70-1/2. It's important to take into account the effect that RMDs will have on your retirement savings – and your taxes. The years before you turn age 70-1/2, when the RMDs begin, can provide an opportunity to help things go more smoothly, but only if you know what to do.


Reducing IRA Balances

One tactic worth exploring is taking assets out of the IRA before it is required – sometimes even when you're still working. Traditional IRA assets can be withdrawn after age 59-1/2 without penalty, although those withdrawals are taxable.

"We routinely advise clients with large retirement assets." explains Steven Strauss, CPA, based in suburban St. Louis. "In this type of scenario, where income drops off in the years between age 60 and 70, we'll often advise clients to begin tapping into their IRA accounts before they have to. It may make sense to take out a sum at a 10 percent or 15 percent tax rate, rather than a future rate which could be double that."

Trimming IRA balances will reduce the amount of the RMDs when they hit, but it's far from a dollar-for-dollar reduction. "It amounts to a four percent reduction in that first year," explains Strauss. "But that impact will increase over time as the percentage of required withdrawals rises."


Making Charitable Contributions

Another strategy is to take advantage of the tax-free option, preserved in the tax code for 2018, of making charitable contributions directly from an IRA. With more taxpayers pushed into the higher standard deduction pool by the new tax law, this can make even more sense now than in the past.



"If your charitable giving doesn't push you past that standard deduction, the option of using it to reduce your future RMD liability may make better sense."
- Steven Strauss

CPA



Converting to a Roth

Rather than the accustomed practice of writing a check, an IRA custodian can be instructed to issue funds directly to a charitable organization, and in doing so forgo the taxes on that withdrawal while trimming future RMD liability.


Converting to a Roth

For those planning on intergenerational wealth transfer, one of the most powerful tools is to consider a Roth IRA conversion, rather than an IRA withdrawal. Any IRA custodian can make this conversion upon request. The amount converted is taxable in that year, a potential advantage during those lower-income years between retirement and RMDs.


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