When you turn 70.5, you have to start taking withdrawals from your retirement accounts. These withdrawals are known as Minimum Required Distributions (MRD’s). The amount that you must take out at age 70.5 is roughly 3.6% of your retirement account balance. That percentage increases each year, so that you are taking out a larger portion of your retirement account as each year progresses.
Many retirees today have saved a majority of their money in traditional IRA or 401(k) accounts. These retirement accounts allow you to defer paying taxes on the money you contribute and its growth. However, once you start taking withdrawals, whatever is taken out is taxed as ordinary income.
One issue that can arise with MRD’s is that once those withdrawals start your tax liability can increase substantially. However, with proper planning done in advance, you can manage these MRD’s and potentially save yourself quite a bit in taxes throughout retirement. Below we discuss 6 ways of doing this.
If you are age 70.5 and still working, you do not need to take Minimum Required Distributions from your current 401(k). This exception only applies to 401(k)’s in which you are still working for the company. If you have a 401(k) from a previous employer then you must take MRD’s from that account.
If your plan allows roll-ins (check with your 401k provider to see if your plan does), you could move your IRA into your active 401(k), which would allow you to defer your MRD’s until you retire.
Lisa is about to turn 70 and works for ABC Company. She plans on working for another 5 years or so. She has an active 401(k) with ABC that she has been contributing to for years. Lisa also has an IRA valued at $400,000.
Lisa checks with her 401(k) provider and they let her know that they accept roll-ins.
If Lisa lets her IRA where it is, then she would have a MRD of roughly $14,598, which she will pay taxes on at her current marginal tax rate. On the other hand, Lisa could roll her IRA into her ABC 401(k). By doing this she wouldn’t need to take her MRD. She wouldn’t have to take an MRD until she retires in 5 years time.
Having money in a Roth IRA/401(k) can offer great benefits for a retiree, since withdrawals from Roth accounts are not taxed. In addition, there are no MRD’s from Roth IRA’s. There are MRD’s from Roth 401(k)’s but that can be circumvented by rolling the Roth 401(k) into a Roth IRA.
Another benefit to a Roth IRA is that withdrawals are not counted as income in determining whether your Social Security benefit will be taxed (see here) and are not counted in determining your Medicare Premium Income Adjustment (see here).
If you can retire with some money in a traditional IRA/401k and some money in a Roth account, you give yourself the ability to better manage your taxes throughout retirement.
This idea is known as tax diversification and, if done properly, this diversification can offer a lot in tax savings. For instance, in a high income year you can withdraw from your Roth IRA, since it’s not taxed. In a year where you are in a lower tax bracket, you can withdraw from your traditional IRA instead, since it will be done at a lower tax rate. Having money in both accounts gives you some ability to mix and match what accounts you withdraw from.
Conversions are different than contributions. With a conversion you convert a piece (or all) of your IRA to a Roth. At the time of the conversion you pay taxes on the amount converted, but then subsequent withdrawals are tax free.
Roth conversions can be a great opportunity for someone whose income has fallen for a few years but they expect it to increase again in the future.
Jeff and Barbara are 60 and recently retired. They have IRA accounts totaling $800,000 and plan to collect Social Security at 70. They have money in savings and taxable investments that they will live off of until 70.
After running some tax projections with their Financial Planner, Jeff and Barbara see that they will be in a low tax bracket for the first 10 years of retirement since they don’t have much income coming in. However, at age 70 they will jump up to a much higher bracket, since they will have Social Security income along with Minimum Required Distributions. Today their marginal tax bracket is 15% while at 70 it will jump up to 28%.
Jeff and Barb should explore converting some of their IRA accounts into Roth accounts over the next 10 years so that they take advantage of the 15% tax rate, rather than wait for it to be eventually taxed at 28%.
You don’t have to wait until 70.5 to take distributions from your IRA’s. Rather, you can withdraw money earlier when you may be in a lower bracket. This process can help smooth out taxes throughout retirement.
Same situation as directly above, but instead of doing Roth conversions, Jeff and Barb take money out of their IRA accounts today to live off of. A $10,000 withdrawal today at the 15% bracket costs $1,500 in taxes. If they wait until 70, that same distribution will cost $2,800 (28% tax bracket). Taking distributions today will also lower what their eventual MRD will be since their IRA balance will be smaller.
You are able to defer a portion of your MRD by buying a Qualified Longevity Annuity (see our post on QLAC’s here).
With a QLAC, you can take the lesser of 25% of your IRA account balance or $125,000 and purchase an annuity that can start making payments as late as age 85. The amount you use to purchase the QLAC will not be considered for RMD purposes.
Tom, age 69, has an IRA valued at $700,000. When he turns 70.5 his Minimum Required Distribution would be about $25,500. If he takes $125,000 and purchases a QLAC, the $125,000 is no longer included in the MRD calculation. He now calculates the MRD on the $575,000 balance. His MRD would be $20,980.
Its important to recognize though that the QLAC should be considered for longevity protection purposes rather than for purely deferring your MRD. If you aren’t concerned about longevity (e.g. health reasons that may curtail your life expectancy) then the QLAC may not be right for you.
If you are charitable inclined, you can donate up to $100,000 of your MRD every year to a charity. The donation must come directly from your IRA; it cannot come from a 401(k).
If you donate your MRD the amount donated is not reported on your tax return, and thus you will have a lower Adjusted Gross Income (which can also help you save money on your state taxes). Obviously enough however, you cant also claim a charitable deduction for that same donation on your Schedule A.
Like all retirement planning tactics, these strategies will only work if you put them in the context of your overall plan. Before you retire think about what type of retirement savings you have, how they will be taxed, and then map out ways to manage those taxes throughout retirement.