If you take a required minimum distribution from an IRA, 401(k), or other tax-advantaged account and don’t need the money to cover your living expenses, where should you keep the unneeded cash?
Investors must now begin taking RMDs at age 73 or, if born after 1960, at age 75. Depending on the balances of your accounts, this distribution could be a significant amount of money, perhaps more than you need to live on. One option is to reinvest the money, and a Roth IRA seems like the perfect choice: Withdrawals from Roth accounts are tax-free—including any gains from your investments—and you don’t have to take any of those pesky RMDs throughout your life.
There’s just one catch: You can’t convert your RMDs directly into a Roth. However, there is a possible workaround for some people. For 2024, you can donate up to $7,000, plus an additional $1,000 if you’re at least 50 years old – as long as you have enough earned income.
Get connected with a financial advisor to discuss your own retirement strategy.
What is – and what isn’t – ‘earned income’
The IRS defines earned income as money you receive for work, such as: B. Wages, commissions, bonuses, tips and fees for speaking, writing or attending a conference or convention. This also includes income from self-employment. Income that does not qualify includes taxable annuity payments, interest income, dividends, rental income, alimony, and withdrawals from Roth IRAs or other non-taxable retirement accounts, as well as pensions, employee benefits, unemployment compensation, workers’ compensation payments, and your Social Security income.
Another limitation of Roth contributions is the income limit. Once your modified adjusted gross income (MAGI) reaches $146,000 for a single filer or $230,000 for joint filers, your maximum Roth contribution begins to rise to $161,000 (single filer) or $240,000 (joint filer). After that, you are no longer eligible to contribute.
You also need to keep in mind that after your first deposit into a Roth account, you’ll have to wait five tax years before you can make withdrawals. Heirs who inherit your Roth must withdraw the entire balance within 10 years.
Consider speaking with a financial advisor to develop a tax-efficient retirement strategy.
More options for RMDs
If you are not eligible to make a Roth contribution, you still have the option to eliminate, reduce, or defer your RMDs.
Roth conversion: You can convert your IRA to a Roth account once you have received your RMD for the year. You pay taxes on the amount you convert. One tactic, therefore, is to convert the maximum amount available without moving into a higher tax bracket. Each Roth conversion has its own five-year rule.
Donation: You can use a qualified charitable distribution to donate part or all of your RMD to an IRS-approved charity without incurring taxes on the amount donated. To qualify, the money must be transferred directly from your IRA to the charity.
Continue working: Your 401(k) account with your current employer is not subject to RMDs if you are still on the payroll. One tactic is to roll over 401(k)s from previous employers into your current plan so they aren’t subject to RMDs. However, once you stop working, RMDs are required.
Be careful: The penalty for failing to take an RMD within the required time period is steep – up to 50% of the missed RMD amount.
A financial advisor can help you navigate the unique risks and trade-offs in your situation.
Pay attention to all your taxes
To structure your retirement withdrawals to reduce your tax burden, you must consider all of your sources of income, including retirement accounts, RMDs, Social Security benefits, pensions, and taxable capital gains. For some people, withdrawing money from an IRA before retirement can reduce the amount of their eventual RMDs. Additionally, if they delay receiving their Social Security benefits, their benefit amount will increase by 8% each year until they reach age 70. Also, be sure to coordinate taxes, withdrawals, and RMDs between spouses, and remember that a younger spouse’s RMDs do not need to be deducted until age 73 or 75.
Other common tax moves for retirement include investing in tax-free bonds, moving to a state without income or estate taxes, taking advantage of tax losses on taxable investment accounts, and holding taxable assets for a long time to qualify for lower long-term capital gains tax rates.
To learn more about retirement planning and achieving your goals, speak to a financial advisor for free.
Bottom line
Managing your RMDs – and all the many other tax questions that may arise in retirement – can be complicated. Take the time to estimate your retirement taxes before you begin collecting pensions, Social Security, and withdrawals from retirement accounts.
Tips
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Balancing taxes and retirement income – and figuring out how to minimize taxes in retirement – is a crucial issue. A knowledgeable financial advisor can help you decide how to structure and coordinate these payments during your retirement.
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Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three vetted financial advisors working in your region, and you can survey your matching advisors for free to decide which one is right for you.
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Make sure you protect your cash reserves from inflation by securing them in an account that generates a competitive interest rate. Leaving cash in a low-yield checking or savings account can affect your purchasing power over time.
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