Retirement accounts like a 401(k) or IRA come with some big advantages. Perhaps the most attractive benefit of these accounts is you can defer your taxes until retirement. Doing so could give you more money to invest today or spend on your living expenses while you work.
But at some point the federal government wants to get paid. That's why it imposes required minimum distributions, or RMDs, on retirement accounts. Anyone age 73 and older must withdraw a certain amount from their tax-deferred accounts by the end of each year. And if you inherited an IRA, you might be subject to RMDs as well.
The best use for RMDs is to fund your living expenses in retirement, though you might have to withdraw more from your accounts than you actually need to spend. In such situations, reinvesting those funds is a great way to increase the amount you can leave to your heirs or donate to charity down the road.
But you have to know what you're doing. Those looking to reinvest their RMDs could easily fall short of meeting their full requirement. And the penalty for missing an RMD is quite steep: up to 25% of the amount you failed to withdraw. Plus, you'll still need to take the distribution and pay taxes on it. So, here's what you need to know if you plan on reinvesting your required minimum distribution in retirement.
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Roth conversions do not count toward your RMD
Roth conversions are a great strategy to keep your money invested in a tax-protected account while reducing your future RMDs. Unfortunately, they won't count at all toward your RMD for the year in which they're made. In fact, you must take your RMD before you can complete any Roth conversions.
On the surface, it might make sense for a Roth conversion to count. After all, you still have to pay taxes on any amount you convert from a traditional retirement account to a Roth account, so the government's getting its money. But the government also misses out on future potential tax revenue as the Roth account remains tax protected, enabling the owner to avoid paying any additional taxes on gains made after the conversion.
A good strategy for those with very high RMDs may be to take their required distribution and then convert funds to a Roth IRA while paying an acceptable tax rate. If you don't need your entire RMD for living expenses, you can use some of the excess to pay the taxes on the Roth conversion. Given the current environment of low tax rates, it might be worth converting a significant amount today with the expectation that tax rates will increase in the future.
Taking in-kind distributions has a big pitfall to watch out for
If you plan to stay invested in some of the same assets you already hold in your retirement account, you can opt to take your required distribution in kind. That means your financial institution will transfer securities to a taxable brokerage account directly instead of selling them and giving you cash.
Using an in-kind distribution allows you to stay invested in your preferred securities, ensuring you don't miss any big days in the market. That's important because you can attribute a huge portion of the returns in the stock market to just a few trading days. The problem is you never really know when those days will occur.
There's a big pitfall to watch out for when taking in-kind distributions, though. Since the value of the securities you're transferring out will fluctuate from day to day, the exact value you withdraw will likely be more or less than your required minimum distribution. If you don't withdraw enough, you could face penalties for not taking your full RMD. If you end up withdrawing more than you have to, you can transfer money back into your IRA if you act fast since you'll only have 60 days to do so.
It's also worth noting that you'll still owe taxes on the distribution. That means you'll need additional cash from another source to cover that expense. It might make sense to take an in-kind distribution for a portion of your RMD and then take the rest in cash to cover your taxes and living expenses.
Make sure you avoid penalties
Few things will eat into your investment gains faster than a 25% tax you never had to pay in the first place. That's why it's paramount to ensure you make your full required minimum distribution.
Even if you plan to keep investing the funds, it might make sense to take the full distribution in cash early in the year to make sure you've covered your bases. That might mean missing out on a few days in the market, but the reassurance will be worth it for some.
Once your RMD is out of the way, you can reinvest any excess cash in a taxable brokerage account and decide whether you'd like to make Roth conversions. Both strategies can offer great advantages for long-term tax and legacy planning.
