After you reach a certain age, you’ll be subject to required minimum distributions (RMDs). This refers to the minimum amount you must withdraw each year from your retirement accounts.
The age for RMDs was recently increased to 72 (from 70½). Now, with the proposed SECURE Act 2.0, it might be further increased to 75.
Why should this concern you? Because RMDs significantly affect your lifetime taxes!
3 Ways to Lower Your Taxes on Required Minimum Distributions
1) Plan Your Tax Situation Ahead of Time
The earlier you start planning, the more likely you are to optimize your lifetime taxes.
In fact, you can avoid a big “tax torpedo” if you plan well ahead of time. If you aren’t aware of the tax torpedo, here’s a quick explanation:
Let’s assume you’re in your early sixties and have just retired. You might not have started Social Security yet. You definitely don’t have RMDs yet. However, as you grow older, start Social Security, and become subject to RMDs, your total income will likely increase.
Based on your other income sources, 0-85% of your Social Security is taxed. If your other income is lower, less of your Social Security is taxed — and vice versa.
So, when your RMDs kick in, the portion of your Social Security being taxed automatically goes up.
For example, if your RMD is $10,000, you’d think that you’re paying extra taxes on only $10,000. But as the RMD increases your total income, the amount of Social Security taxable might also increase by $8,500. This increases your total taxable income by $18,500!
It gets worse when this increase in taxable income pushes you into a higher tax bracket. Let’s say you move from the 12% bracket to the 22% bracket. 22% * $18,500 = $4,070. In other words, while withdrawing $10,000, you end up paying nearly a 41% tax cost! This is what we mean by the tax torpedo.
Another situation you need to prepare for ahead of time is the death of a partner (if you’re entering retirement as a couple). Once you start filing as a single individual, your taxes can rise quickly! That’s why it’s important to plan for the surviving spouse ahead of time.
Think of your taxes as a teeter-totter. You need to balance them throughout your lifetime. If you pay too little taxes now, you might end up in a much higher tax bracket later. On the other hand, if you pay too much upfront, you might face a higher tax rate now.
To learn more about efficient tax planning, check out: 5 Ways to Improve Your Tax Picture in Retirement.
2) Charity Through Your IRA
To all the charitably-inclined retirees out there, there are ways in which you can donate in a tax-efficient manner.
One of them is using qualified charitable distributions.
It means transferring money directly from your IRA to your preferred charities. This way, it doesn’t show up on your tax return. (Note: The minimum age for qualified charitable distributions is 70½.)
You might wonder, “How is it different from getting itemized deductions?”
First, in light of recent tax law changes, you might not get the itemized deductions at all. But even if you do, it’s less beneficial from a tax standpoint.
Let’s say you withdraw $10,000 from your IRA and then donate it to a charity. Your income is shown as $10,000 and you receive a deduction of $10,000 in return. So, the net taxable income is zero, right? WRONG!
Taking money out of your IRA increases your provisional income, which will affect the extent to which your Social Security is taxed. This can increase the taxable portion of Social Security by $8,500 (as mentioned above).
Plus, when it comes to itemized deductions, the higher your income upfront, the lower your medical deductions allowed.
3) Roth Conversions
You can control your required minimum distributions, even if you’re already past the minimum age for taking them.
Your RMD amount is based on the value of your traditional accounts at the end of last year.
As a result, you can’t change the RMD for the current year (although you can donate them using qualified charitable distributions). However, you can control your RMDs for the upcoming years.
Through Roth conversions, you can reduce the value of your traditional accounts, which will ultimately lower your RMDs.
Don’t let anyone ever tell you, “You’re too old to do Roth conversions.” 70, 70½, 72, 75… whatever your age is, you can always take advantage of Roth conversions.
By transferring your money to a Roth IRA, you can decide the year in which your traditional money will get taxed and, to some extent, the tax bracket you fall into.
The more money you transfer to a Roth account, the lower your RMDs will be in the future.
Keep in Mind
A lot of people have a misconception that the RMD amount is the maximum you can withdraw.
That is not the case! The ‘M’ in RMD stands for “minimum” and it is only the minimum amount you need to withdraw. You can always withdraw more money if you need it.
You can also be subject to RMDs on inherited IRA accounts. This area is more complicated, and we think it’s best to consult an expert like us. We are part of Ed Slott’s Elite IRA Advisor Group and have access to great information from some of the best IRA experts in the country!