In the year that a required minimum distribution (RMD) is due from a 401(k), IRA, or other pre-tax retirement account, you must withdraw a certain amount and pay your taxes due to avoid a 50% penalty . But that doesn’t mean you can’t do anything about it and the taxes that come with it. With proper planning, you can absolutely reduce or even eliminate the impact of minimum distributions.
Here’s how you should think about it. And if you want a professional to guide you through an appropriate strategy, you can contact a financial advisor for free.
What are required minimum distributions?
A required minimum distribution (RMD) is a rule that applies to pre-tax retirement portfolios such as 401(k), 403(b), and IRA plans. There are no required minimum distributions for taxed portfolios or for after-tax Roth accounts. This is relatively new, as the RMD rule applied to Roth 401(k) and Roth 403(b) portfolios prior to 2024. This will end from 2024.
The RMD rule requires that you begin withdrawing funds from all applicable pre-tax portfolios at some point. Once you turn 73, you must withdraw a minimum amount from each pre-tax portfolio by the end of the year. You can withdraw this money at any time and in any increments as long as you withdraw the full amount by December 31st.
This rule applies separately to each applicable pre-tax portfolio. Let’s say you have a 401(k) account and a traditional IRA account. Each portfolio has its own minimum distribution.
You are free to withdraw more than the minimum amount. You can also use this money in any way you want, including reinvesting it in a taxed portfolio, although you can’t reinvest a minimum distribution withdrawal in a Roth IRA.
As always with a pre-tax portfolio, when you withdraw that money, you pay income taxes on it. This is the purpose of minimum distributions because the IRS wants to ensure that you end up paying some taxes on a pre-tax portfolio.
If you do not withdraw the minimum distribution from a particular portfolio, you will generally be charged a 50% excise tax on the amount not withdrawn. For example, let’s say you underutilize your account by $5,000. The IRS may charge you up to $2,500 in taxes due to this error. If you make a mistake, the IRS may waive some tax penalties in some situations. This most often occurs when you voluntarily report and correct your error and when the error was made in good faith.
This is how required minimum distributions are calculated
Required minimum distributions apply for two periods:
First, for the year in which you turn 73, you have until April 1 of the following year to take that year’s distribution. Suppose you turn 73 in 2024. You must make a minimum distribution for 2024 and have until April 1, 2025 to pay it out. In certain circumstances, this may change for employer-sponsored retirement plans.
Secondly, you have until December 31st for all subsequent years to make the full distribution for that year. For your first year’s minimum distribution, this could mean doubling your payout in one year. For example, in our example above, you could make a withdrawal on March 31, 2025 and December 30, 2025.
For each year and for each pre-tax account, the minimum distribution is calculated as follows: the account balance at the end of the previous calendar year divided by your uniform lifetime distribution period.
The distribution period is a value based on your age and marital status. It is published in a series of tables by the IRS. It decreases with each year of life and increases your RMD needs proportionally as you age.
Suppose you are 75 years old and unmarried. On December 31 of last year, you had an IRA with a balance of $500,000. Your RMD would be:
You must withdraw at least $20,325 from this IRA by December 31 of this year.
A financial advisor can help you calculate your RMDs and see how they affect your retirement income. Get matched for free.
Can you reduce your required minimum distributions?
All of this leads us back to the main question of this article. How can you reduce your required minimum distributions? And how can you specifically reduce the associated tax implications?
There are two answers to this question.
First, there is little you can do to reduce your obligations for the year in which an RMD is due. Your minimum distribution is required and is calculated on January 1st of each year based on the portfolio values as of December 31st of the previous year. You must withdraw at least this amount.
Second, you can reduce your future RMD needs through advanced planning.
The most effective ways to address this include:
Make a qualified charitable donation
To the extent that you need to withdraw this money, you can manage your tax position with what is known as a “Qualified Charitable Distribution.” (QCD) With a QCD, you transfer cash or assets from your pre-tax portfolio directly to a qualified charity. Your donation is not considered taxable income and will count toward your minimum distribution for the year.
The IRS limits the amount of annual QCDs, with the maximum set at $105,000 for 2024.
From an immediate perspective, qualified charitable distribution will leave you financially poorer. While you don’t pay taxes on this money, you don’t keep the rest either (unlike a distribution, where you keep the after-tax portion of your payout). However, because this doesn’t count as taxable income at all, your overall tax bracket stays low, which can help reduce the taxes you pay on other income and assets.
Do a Roth conversion
Assets held in a Roth IRA are not subject to minimum distributions or taxes. Converting pre-tax assets into a Roth IRA therefore eliminates your RMD requirements for the amount you convert. You can convert qualifying assets at any age and in any amount. The only significant limitation is that you cannot roll RMD withdrawals into a Roth IRA.
The year you make a Roth conversion, you will pay income tax on the entire amount you convert. The typical approach to this is to stagger your conversions, which can reduce the tax rates for each year and the associated tax rates. However, if you are currently concerned about RMDs, you need to find a balance.
The more you convert in a year, the higher your rates will be and the more you will pay in total conversion taxes. However, the faster you convert your assets into a Roth portfolio, the fewer minimum distributions you will have to accept. Every year that you fluctuate your conversions is another year that you may need to purchase RMDs. However, to avoid penalties, you must let your money convert to the Roth IRA for five years before withdrawing it.
Still, for many retirees, a Roth conversion won’t help protect their money. When you do a Roth conversion, you withdraw money from your portfolio on a pre-tax basis and pay taxes on the amount withdrawn. If your goal is to avoid RMDs, which force you to withdraw money from your pre-tax portfolio and pay taxes on it, then a mid-retirement conversion can defeat the entire purpose. This is often best used as a tool for future retirement planning.
Roth IRA conversions can be difficult and often have significant and immediate tax consequences. It may be best to speak with a professional fiduciary advisor before executing any plan.
Structure your distributions
A good way to manage your long-term RMD needs is to structure your withdrawals into different accounts. In particular, try to generate pre-tax income from your portfolios first. This reduces the value of your portfolios subject to minimum distributions, allowing your other assets to maximize their growth in the early years of your retirement. For example, if you have both a 401(k) and a Roth IRA, you take money from your 401(k) first and then take income from your Roth IRA later in retirement.
If you want, you can maximize the value of this approach by starting to withdraw assets from your pre-tax portfolio at age 59 1/2 (the earliest you can generally do so without penalty). You can transfer these assets into a taxed portfolio that does not have minimum distributions. However, as with Roth conversions, this is a compromise. By withdrawing money from your pre-tax portfolios sooner, you reduce your risk of minimum distributions in the long run. However, you also have to sacrifice the tax-deferred growth of these portfolios, potentially reducing your overall after-tax financial position.
Invest in pensions
Finally, you can restructure your investments around annuities.
Although this rule presents some complications and exceptions, you generally do not have to calculate minimum distributions for an annuity. More specifically, the income your pension generates is subject to income tax unless it is part of a Roth portfolio. This income and associated taxes are assumed to satisfy all RMD requirements for a pre-tax portfolio. This is not a hard and fast rule, but it will work for most households.
A financial advisor can help you identify the right retirement products to avoid RMDs and meet your needs.
The conclusion
Required minimum distributions are the amount you must withdraw each year from each pre-tax portfolio you own. While you cannot reduce your withdrawal requirements for the current year, you can restructure your RMD requirements for future years.
Tips for investing around your RMDs
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This is a topic with many different strategies and options. If you want to manage your RMDs, our strategies here will help you. And here are six more strategies for managing your minimum distributions over the long term.
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A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three verified financial advisors working in your region, and you can have a free discovery call with your matching advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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