How to Plan For and Handle Required Minimum Distributions (RMDs)
“Whoa! How much am I going to have to pay?”
These were the words of a client I recently met with, who is approaching retirement age and had questions about Required Minimum Distributions (RMDs). She had heard about them but wasn’t sure exactly what they meant or how they would impact her financially. Looking at some projections, she was shocked to discover she would need to take $50,000-$70,000 annually in RMDs. This amount almost doubles her income and significantly increases her tax burden.
Her jaw dropped when she realized the tax implications. This is a common reaction I see when clients first understand the full impact of RMDs on their retirement plans. Are you in a similar situation? Wondering about RMDs and wondering about RMDs and their tax consequences? Let me walk you through what I explained to my client.
What is the Required Minimum Distribution?
The Required Minimum Distribution is exactly what it sounds like. It’s the minimum amount the IRS requires you to withdraw from your retirement accounts annually after reaching a certain age. These withdrawals are mandatory for traditional IRAs, 401(k)s, and similar tax-deferred retirement accounts.
When Do RMDs Start?
Understanding the required minimum distribution age is crucial for proper retirement planning. The age at which RMDs begin has changed several times due to recent legislation. It used to be 70½, then it was bumped to 72, and now it’s 73 for anyone born before 1960. For those born in 1960 or later, the required minimum distribution age will be 75.
This means that by April 1 of the year following the year you turn the required age, you must take your first RMD. For example, if you turn 73 in 2025, you have until April 1, 2026, to take your first distribution.
Note
Be careful with this April 1 deadline for your first RMD. Why? Because you may find that you need to take two distributions in the same tax year. The first RMD by April 1, and the second by December 31. A double distribution could significantly impact your tax situation.
How to Calculate RMD Using IRS Tables
Learning how to calculate RMD correctly can help you avoid costly penalties. The calculation process is relatively straightforward but requires attention to detail.
To determine your required minimum distribution, you take the value of your retirement account as of December 31 of the previous year and divide it by a life expectancy factor provided by the IRS. You can find these factors in the IRS tables and are based on your age.
Example
Let’s say you have $1,000,000 in your IRA on December 31. The IRS Life expectancy factor for you is 25.6. Your RMD would be approximately $39,063 for that year ($1,000,000 ÷ 25.6).
The percentage starts around 4% at the beginning and increases each year as your life expectancy decreases. My client was looking at RMDs of $58,000-$59,000 annually, which made her quite concerned about the tax implications.
It’s important to note that you must calculate your 401(k) required minimum distribution separately from your IRA distributions. Unlike IRAs, which can be aggregated for RMD calculations, each 401(k) account requires its own separate calculation.
Many financial institutions offer an RMD calculator on their websites to assist their clients with these calculations. Using an RMD calculator can help you determine exactly how much you need to withdraw each year based on your specific situation.
Strategies to Minimize the Tax Impact of Required Minimum Distributions (RMDs)
After discussing the basics with my client, we explored several strategies to potentially reduce the tax impact of her RMDs. Here are the three main approaches we are considering:
1. Qualified Charitable Distribution
Qualified charitable distributions allow you to donate up to $100,000 per year directly from your IRA to qualified charities or nonprofits. This amount counts toward your RMD but not your taxable income. It can effectively allow you to satisfy your RMD requirement without the associated tax burden.
QCDs are only available for IRAs, not 401(k)s. You can roll over a 401(k) to an IRA if this strategy appeals to you. Note that there are pros and cons to consider before doing so.
2. Roth Conversion Strategy
Another approach is to convert some of your traditional IRA or 401(k) funds to a Roth IRA before reaching RMD age. While you’ll pay taxes on the converted amount in the year of conversion, this strategy can reduce your future RMDs and provide tax-free growth going forward.
This strategy works particularly well if you retire before RMD age and have years with lower income. For example, if you retire at 63 and your income drops significantly, you might be in a lower tax bracket. You could convert some of your traditional retirement funds to a Roth IRA, paying taxes at this lower rate.
The benefit is twofold.
- You pay taxes at a potentially lower rate now.
- The converted funds will grow tax-free in the Roth IRA with no future RMDs required.
This can significantly reduce your tax burden in later years.
3. Qualified Longevity Annuity Contract
A less common but potentially useful option is a Qualified Longevity Annuity Contract (QLAC). This is a type of annuity that allows you to invest up to $100,000 from your IRA or 401(k) and defer RMDs on that amount until age 85.
The QLAC essentially pushes back the RMD requirement for a portion of your retirement savings, giving you a 10-year window where you don’t have to take distributions on those funds. Congress created this option specifically to help retirees set aside money for their later years, providing financial security as they age.
While QLACs may not be suitable for everyone and require careful consideration, they represent another valuable tool in your retirement planning toolkit.
When Do RMDs Stop?
Unlike some retirement rules, there is no age at which RMDs stop as long as you own the account. Required minimum distributions continue throughout your lifetime, with the percentage increasing each year based on the IRS life expectancy tables.
This ongoing requirement makes it all the more important to develop a comprehensive strategy for managing your RMDs and their tax implications as part of your overall retirement plan.
Planning for Your Required Minimum Distribution
Understanding your required minimum distribution is essential for effective retirement planning. The strategies I’ve outlined – qualified charitable distributions, Roth conversions, and QLACs – are just some of the approaches that might help minimize the tax impact of your RMDs.
For my client, we are developing a personalized strategy combining several of these approaches to address her specific financial situation and goals. The right approach for you will depend on your individual circumstances, including your:
- Current and projected future tax brackets
- Charitable intentions
- Overall retirement plan
If you’re approaching retirement age and haven’t considered how RMDs will affect your financial situation, I encourage you to start planning now. Remember, with proper planning, you can take control of your RMDs rather than letting them control your retirement tax situation.
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