Four ways to reduce the tax impact of annual IRA required minimum distributions that investors need to start taking by age 73.
After enjoying exceptional tax-deferred growth over the past decade, many retirees now view their individual retirement accounts as tax time bombs. Bloated retirement assets are, of course, a good problem to have. But the tax treatment of IRAs can take a toll.
By age 73, retirees must begin annual required minimum distributions, or RMDs, which are taxed at income-tax rates of up to 37% rather than at capital-gains tax rates, which top out at 20%.
RMDs can push you into a higher tax bracket, disqualify you from income-sensitive deductions and credits, and trigger higher Medicare premiums.
But don’t resign yourself to a tax drubbing. Here are ways to reduce the tax impact of your IRA assets:
Gift From Your IRA
If you don’t need RMDs to live on, you can avoid them by gifting to charity directly from your IRA through a qualified charitable gift, or QCD, which counts toward your RMD obligation. This year, you can give up to $111,000 through a QCD.
You won’t get a charitable deduction, “but the fact that your RMD isn’t increasing your income means you’re effectively getting the deduction,” says Stephen Baxley, head of tax and financial planning at Bessemer Trust.
Convert IRA Assets to a Roth
Roth IRAs have no RMD requirements, so converting traditional IRA assets to a Roth can make sense. Principal can be taken out tax-free anytime, and withdrawals of growth are tax-free after five years. If you bequeath a Roth, heirs’ withdrawals are tax-free.
You do, however, pay income taxes on converted assets. If you plan on living on IRA assets, a careful analysis is needed to determine if the tax will be offset by the conversion’s benefits. The younger you are, the better: It could take years of growth to make up for the tax.
If you plan to leave IRA assets to heirs, a conversion even late in life can still make sense. An added gift to heirs: Tax on the IRA assets comes out of your pocket, not theirs.
The ideal time for a conversion is after you retire but before you draw Social Security and RMDs, because that’s when your tax rate is likely to be lower than usual, says Michelle Soto, a partner at Cerity Partners.
You can also convert in chunks of IRA assets annually. In that case, aim for an amount that fills your tax bracket but doesn’t push you into the next bracket, Soto says.
Tap the Breaks on IRA Growth
If you hold growth stocks mainly in taxable accounts and bonds in your IRA, that could pare your future RMDs. “With slower growth, your future RMDs will be calculated off a lower base,” Soto says.
Plan Your Annual RMD
RMDs must be taken out before year end, but you can choose when within the year. The amount won’t change; it is determined based on your IRA’s value at the end of the prior year. But there are reasons to consider an early-year lump sum.
“Some folks take it early so they don’t forget,” says Tara Thompson Popernik, head of wealth planning at LPL Financial.
Failure to take RMDs results in a 25% penalty, or 10% if the mistake is corrected within two years. “But the academic answer is to wait until year end so you get almost a full year’s tax-deferred growth,” Popernik says.
If you need RMDs for expenses, consider monthly withdrawals, says Jane Ditelberg, chief tax strategist at Northern Trust Wealth Management. “It’s the same philosophy behind investing steadily regardless of market behavior. Withdrawals come out when the market is high, some when it’s low, and it averages out.”