Key Points:
- Roth conversions and Qualified Charitable Distributions can help manage taxable income and reduce future RMD obligations.
- Proactive withdrawals and asset allocation strategies may prevent large tax hits in later years.
- Required Minimum Distributions can be used strategically to cover qualified expenses and potentially unlock deductions.
Once you turn a certain age, Required Minimum Distributions (RMDs) from tax-deferred retirement accounts like Traditional IRAs and 401(k)s become unavoidable. For those born in 1950 or earlier, your RMDs begin at 72. For those born between 1951 and 1959, RMDs begin at 73. For everybody else, they begin at age 75.
These mandatory withdrawals are considered taxable income, which can unexpectedly push you into a higher tax bracket, affect Medicare premiums, or trigger additional taxes.
Fortunately, there are several ways to navigate this challenge. By planning ahead, you may be able to soften the tax blow of RMDs and even turn them into a financial advantage.
Here are five strategies that could help reduce the tax burden of RMDs in retirement:
1. Consider Roth Conversions to Limit Future RMDs
Roth IRAs aren't subject to RMDs, which makes them a valuable planning tool later in life. Gradually moving funds from a Traditional IRA to a Roth IRA can reduce the size of accounts subject to future RMDs. This strategy may be especially effective in lower-income years.
Keep in mind: Converting to a Roth is a taxable event in the year it happens. That’s why it is important to weigh the short-term tax hit against long-term savings.
WealthTrace can help you determine if a Roth Conversion may be worthwhile. Our Roth Conversion scenario will show you how much to convert, and in what year, to maximize your savings and minimize your total taxes paid.
2. Make Charitable Contributions Directly from Your IRA
If charitable giving is part of your retirement objectives, Qualified Charitable Distributions (QCDs) can serve as a highly tax-efficient strategy. A QCD allows individuals aged 70½ or older to transfer up to $100,000 annually directly from an IRA to a qualified charitable organization.
These distributions count toward your RMDs but are excluded from taxable income, making them particularly advantageous for those who do not itemize deductions. Additionally, because QCDs do not increase your Adjusted Gross Income (AGI), they can help mitigate the potential impact on income-based factors such as Social Security taxation and Medicare premium surcharges.
Qualified Charitable Distributions can be incorporated into your financial plan within WealthTrace, enabling you to visualize the potential impact of reducing taxable income from RMD’s.
3. Withdraw Strategically to Manage Future Tax Brackets
Even if the income is not immediately needed, taking additional distributions prior to the onset of larger RMDs can be an effective strategy for mitigating future tax liabilities.
By strategically withdrawing funds while you are still in a lower tax bracket, you may reduce the balances in tax-deferred accounts, thereby decreasing the size of future RMDs. Many retirees choose to reinvest these withdrawals in taxable brokerage accounts, allowing the assets to continue growing while maintaining greater financial flexibility.
The key to this approach is careful planning: withdrawing enough to reduce future tax exposure without unnecessarily accelerating current tax obligations.
WealthTrace provides the flexibility to customize the withdrawal order of your investment accounts to align with your specific retirement income strategy. By default, the software draws from income sources first, followed by taxable/tax-advantaged accounts, and lastly from qualified tax-deferred accounts.
If you wish to prioritize withdrawals from tax-deferred accounts, you can override the default sequence by creating custom goals and linking them to specific accounts. Alternatively, you can adjust account settings to delay access to taxable accounts, either by specifying a future start date or by designating them to be used last in the plan.
4. Optimize Your Investment Mix Across Account Types
Your asset allocation can significantly impact the growth of your retirement portfolios and, by extension, the size of your RMDs.
A common approach involves holding lower-growth or income-producing investments, such as bonds or dividend-paying stocks, in tax-deferred accounts, while allocating higher-growth assets, such as equities, to Roth IRAs or taxable accounts. This strategy can help minimize the compounding growth of balances subject to RMDs, while allowing more tax-efficient growth in other account types.
It is essential to ensure that any asset allocation strategy aligns with your overall risk tolerance and long-term financial objectives.
WealthTrace allows you to view your comprehensive asset allocation across all investment accounts and model a variety of asset allocation scenarios to support informed decision-making.
5. Use RMD Funds for Tax-Advantaged Expenses
Rather than simply placing your RMDs into a savings account, consider using them strategically to cover qualified expenses. Costs such as healthcare, long-term care insurance premiums, or essential home modifications can help reduce the financial impact of RMDs.
In some cases, these expenditures, particularly out-of-pocket medical costs, may qualify as itemized deductions if they exceed a specified percentage of your Adjusted Gross Income (AGI). By applying RMD funds to these qualified expenses, you not only meet IRS withdrawal requirements but may also offset a portion of the associated tax liability.
This approach allows you to put your RMDs to productive use, turning a tax obligation into a potential financial advantage.
The Bottom Line
While Required Minimum Distributions are mandatory, there are effective strategies available to help manage and potentially reduce their tax impact. Through thoughtful planning, including Roth conversions, charitable giving, strategic withdrawals, asset location, and targeted spending, you can take proactive steps to preserve more of your retirement income.
It’s important to recognize that tax planning in retirement is highly individualized. Factors such as your income sources, financial objectives, and risk tolerance all play a critical role in determining the most effective approach. WealthTrace enables you to model and compare these strategies, helping you create a personalized plan tailored to your unique financial situation.
Do you know how much your RMDs will increase your taxes later in life? If you aren’t sure, sign up for a free trial of WealthTrace to build your financial and retirement plan today.