One of the perks of 401(k)s and traditional IRAs is tax deferral. Any amount you contribute today reduces your taxable income for this year and you won't have to pay any taxes on that amount until you withdraw the money. But you can't put this off indefinitely. When you reach age 70 1/2, Uncle Sam comes calling for his share of your savings.
The way the government gets its bite is through required minimum distributions (RMDs), and if you're not prepared to take these withdrawals from your accounts, they can deal a serious blow to your retirement savings. You may be forced to withdraw more than you intended in a year, and this could raise your income taxes. Or you can get dinged by the 50% penalty, if you forget to take your RMD. Fortunately, there are some things you can do to reduce or delay your RMDs to help avoid these problems. I explain four of them below.
How required minimum distributions are calculated
All retirement accounts require RMDs for adults 70 1/2 and older, with two exceptions: Roth IRAs and your 401(k) with your current employer. The money in Roth IRAs is taxed when you contribute it, so the funds are yours to keep after they grow and you withdraw them. As for your 401(k) with your current employer, you can delay RMDs from this account as long as you continue to work and don't own more than 5% of the company you work for. You can leave money in a Roth IRA for as long as you like or never touch it at all, but for traditional IRAs and 401(k)s, the rules are more complicated.
For most people, RMDs are calculated based on the Internal Revenue Service (IRS) Uniform Lifetime Table. You take the total balance of your account on Dec. 31 of the previous year and divide it by the distribution period for your age listed in this worksheet. The exception is if your spouse is the sole beneficiary of your retirement account and is more than 10 years younger than you. In that case, you would use this worksheet. You must take your distributions for this year by Dec. 31, unless this is the year in which you turn 70 1/2 in which case you can wait until April 1 of the following year.
You're required to withdraw your RMDs from your retirement accounts each year and you'll have to pay income tax on this amount. The trouble comes when the withdrawal pushes you into a higher income tax bracket, so you lose more money to the government.
Deciding not to take the RMD is not an option, as failure to take RMDs by the deadline results in a 50% tax penalty on the amount you were supposed to take out. You'll want to include this on your annual financial checklist, to make sure you don't forget and fail to withdraw your RMD.
You can reduce your required minimum distributions
You can begin drawing upon your retirement savings at 59 1/2 without paying an early withdrawal penalty, but you won't have any RMDs at this point. Any money you take out of your retirement accounts before you reach 70 1/2 will lower the RMDs that you do eventually take, because they're calculated based on the total balance of your account at that time and every year thereafter. So if you can afford it, consider withdrawing more money from your 401(k)s and traditional IRAs in the early years of your retirement before you have to start taking RMDs. However, this strategy will raise your taxable income in the earlier years of your retirement, so prepare accordingly.
Another option is to convert your other retirement accounts to a Roth IRA. You must pay taxes on the money in the year that you make the conversion, but if you convert small amounts at a time and you're in a lower income tax bracket, the hit may not be as severe as it would be if you were forced to take a large RMD later on. If you have a Roth IRA account set up, all you need to do is request a direct rollover of some or all of your 401(k) funds to your Roth IRA. You can reach out to your 401(k) plan administrator or your company's HR department if you need help completing the conversion.
If you continue working past age 70 1/2, you may not have to take RMDs from your current 401(k), as long as you don't own 5% or more of the company you work for. This rule does not apply to IRAs or 401(k)s held by former employers, though you may be able to roll your any 401(k)s held by former employers over into your current 401(k). RMDs will begin according to the schedule in this worksheet in the year that you finally retire.
Another option is to donate your RMDs to charity. The IRS allows up to $100,000 in charitable distributions from an IRA each year. You aren't eligible for a charitable deduction on your taxes, but you also won't be taxed on the amount that you withdraw from your account. It's a nice deal if you already planned to donate to charity. Otherwise, it's a bit of a wash because you won't see any of the money, but you also won't pay taxes on it.
It's important to understand how much you can expect to pay in RMDs each year so you can be prepared come tax time. If you're concerned about losing a lot of your retirement savings to the government, try some of the tips above to help you hold onto more of your money.