How to Take RMDs to Avoid Taxes

Published on: Aug 22, 2023
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By Dan Benson, CFP.

Making smart financial moves in your working years can set you up for a comfortable retirement. Saving money in an employer-sponsored 401(k) or traditional individual retirement account (IRA) helps you build wealth for the long term—plus save on taxes in the present.

But eventually, you’re obligated to take taxable withdrawals from your retirement accounts at age 73 as part of what’s called required minimum distributions (RMDs).1 If you’re wondering how to avoid taxes on RMD payouts, let’s go over some strategies you can use to minimize their impact.

In this article, you’ll learn:

  • Answers to frequently asked questions about your tax-deferred investments
  • Age requirements around RMDs
  • Strategic ways to take your RMDs and potentially avoid taxes

Is a 401(k) Taxed?

401(k)s and other traditional retirement accounts are tax-deferred; meaning contributing to those accounts reduces your taxable income that year. You will, however, pay taxes on those investments upon distribution.

You can start receiving those distributions without early withdrawal penalties at age 59 ½.

By the time you turn 73, you are actually required to make withdrawals.2 These withdrawals are called Required Minimum Distributions.

What Are Required Minimum Distributions (RMDs)?

Required Minimum Distributions (RMDs) are minimum amounts that you must withdraw each year from your traditional IRA, 401(k), 403(b), or other employer-sponsored retirement savings plan once you’ve reached the mandatory age for making withdrawals.

How Much Do You Have to Withdraw From RMDs?

Like most things related to personal finance, the answer here is just that: it’s personal. The amount you need to take with your RMDs depends on several factors, including your age, the balance of your retirement accounts, and the applicable IRS guidelines.

The IRS provides tables to determine the minimum distribution amounts based on your age and the account balances. These tables factor in life expectancy to determine the annual withdrawal percentage. For example, if you’re 72 years old, the IRS requires you to withdraw approximately 3.91% of your retirement account balance as your RMD.

It’s critical to note that RMD rules can vary depending on the type of retirement account and specific circumstances. Failing to withdraw the required amount may result in penalties, including a 50% excise tax on the undistributed portion. Talk with a financial advisor or tax professional who can evaluate your unique situation and provide accurate guidance based on current IRS regulations.

At What Age Do RMDs Stop?

Being required to take a certain percentage out of your traditional retirement accounts every year can be frustrating if you don’t need the money right then. So, you may be wondering, is there an age when RMDs stop and you don’t have to take money out?

Unfortunately, the answer is no. RMDs don’t stop once they begin. You will have to take the amount required by the IRS by the end of each calendar year. But let’s talk about how to take them strategically and pay as little taxes as possible. . .

1.   Take RMDs and Avoid Taxes by Donating to Charity

This is one of our favorite hacks for generosity and saving on taxes!

Qualified Charitable Distributions (QCDs) allow you to transfer money directly from a traditional IRA to an eligible nonprofit. Your donation will count toward your RMDs, but you won’t have to pay taxes on it!

A couple notes on QCDs:

  • If you want to do this with a 401(k), you’ll need to roll those funds over to an IRA first. You can’t make a QCD directly from a 401(k).
  • The organization you donate to must be qualified and approved by the IRS. Learn how to vet a charity here.

2.   Use a Roth Conversion to Minimize RMD Taxes

Here at Beacon, we say, “You can play now and pay later, or pay now to play later.” What we mean is that Uncle Sam is going to want his taxes sooner or later, and we think it’s helpful to pay up while you’re still working—instead of waiting until you’re on a totally fixed income.

So if you’ve been making contributions to a traditional retirement account most of your career—i.e. taking the tax advantage along the way—you might consider a Roth Conversion.

Converting to a Roth will mean that you owe regular income tax on any assets that you roll over. While that might hurt a bit at the end of this tax year, think about how relieved you’ll feel when you don’t owe as much in retirement.

An experienced financial advisor can help you weigh the benefits of using a Roth conversion to minimize RMD taxes.

3.   Defer RMD taxes with an annuity

An annuity is an insurance contract that can provide a steady stream of income throughout your retirement until you pass away. There are many different types of annuities, but when you purchase one called Qualified Longevity Annuity Contract (QLAC) using funds from a 401(k) or IRA, the amount you spend is tax-deferred. That means you won’t owe the taxes until you start receiving those payments. The maximum age for triggering those payments is 85, which means you could potentially buy yourself another decade or more of saving taxes.

Once your QLAC begins making payments, that money is subject to income tax. But until then, you can keep your tax dollars and use that money however is best for you.

Annuities aren’t for everyone, but it’s a good idea to speak with your financial advisor to determine if an annuity can help you reach your goals.

Avoid Overpaying in Taxes Today

In his retirement planning book, “Retiring Well,” Michael Reece, CFP, makes the case that a Certified Financial Planner is better suited to create a tax plan for your retirement than a regular CPA would be. That’s because a financial planner will be looking and planning ahead.

Tax planning isn’t one-size-fits-all. There are many factors to consider when determining the best tax strategy for you, like when you’re going to claim Social Security, the amount of money in your investments, when you’re going to retire, and more. My team is ready to help you navigate the challenges of creating a strong retirement income plan. Give us a call any time: 615-716-2061.

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