One of the biggest advantages of investing in retirement accounts is the tax advantages. Contributions to an IRA or 401(k) are tax-deductible the year you make them. On top of that, any dividends or capital gains in the account don't incur any taxes either. The only time you'll pay taxes on your retirement savings is when you're ready to spend them.
But you can't put off taxes forever. Eventually, the government wants its take. It also imposes required minimum distributions, or RMDs, on seniors' tax-deferred retirement accounts starting at age 73. If you inherited an IRA, you may also be subject to RMDs regardless of how old you are.
But taking an RMD, especially one where you don't need the money to spend right now, can impose a major tax burden on some households. And the problem can get worse and worse each year as your RMDs get bigger and bigger. However, those who plan to reinvest their RMD outside of their retirement account could benefit from taking their distribution right now. Here's why it could be a brilliant move.
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How the government calculates your RMD
There are only a couple of factors that go into calculating your required minimum distribution.
- The age you'll reach this year.
- The balance of your retirement account at the end of the previous year.
The IRS publishes a table of life expectancy factors, which is a number based on how long the average person your age can expect to live. If you want to calculate your RMD yourself, you simply look up your life expectancy factor in the table and multiply it by your account balance at the end of the previous year. (If your sole beneficiary is your spouse and they're more than 10 years your junior, you'll use a special joint life expectancy table that can lower your RMD.)
You can't control how old you are, but you can exercise a little bit of control over the balance in your retirement accounts by being more strategic with when you take your distributions. And right now, the market is presenting you with an opportunity to be strategic.
Take the opportunity the stock market is giving you
The assets in your retirement account typically go up over the long run (hopefully). But every so often, they'll experience a short-term decline in value. That's a great opportunity to take your distribution and reduce your future RMDs. Here's how it works.
Note that the S&P 500 has declined more than 12% year to date as of this writing. If you held an S&P 500 index fund in your retirement account and you took your RMD entirely from that fund, you'd end up withdrawing roughly 14% more shares than you would have if you took your distribution on Jan. 1.
Reinvesting those shares in a taxable brokerage account will allow you to start accruing unrealized capital gains over time. So, instead of paying high income tax rates on the future gains in the investment, you'll only be subject to capital gains tax rates. If you hold the shares in your taxable account for more than one year, you'll pay a lower tax rate on any gains than your normal income tax rate. And if you keep them aside and pass them on to your heirs, they'll receive a step-up in basis, completely erasing the taxable gains you made.
The same principle makes Roth conversions a great option for retirees when stocks are down but you'll need to take your RMD before you can make a Roth conversion.
It's important to note that this strategy only makes sense if you intend to reinvest your required minimum distribution in a taxable account. If you need your RMD for your regular living expenses in retirement, then you likely want to maximize the value you're getting for your investments when you liquidate them. That means you should hold your stocks and turn your attention toward selling assets that have climbed in value. What's more, you don't need to sell until you need the cash.
But for those who don't need all of their RMD right now, taking at least part of your distribution while your investments are down is the retirement equivalent of "buying the dip." You'll set yourself up for smaller RMDs in the future, and you'll position yourself for lower taxes as well.
