If you're approaching retirement -- or you just want to know more about it in order to better plan for retirement -- you need to know about required minimum distributions (RMDs) -- and how you might best use them.
Here are some smart ways to use them, and an important caution, too.
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1. Spread out your first two RMDs
You have until April 1 of the year after you turn 73 to take your first RMD. For all RMDs after that, the deadline is Dec. 31. So your second RMD will be due by Dec. 31 of the year you turn 74.
While you could take both your first two RMDs in the year you turn 74, it can be smart to spread them out. Taking them both in one year can significantly increase your taxable income for that year, potentially bumping you into a new tax bracket.
2. Take your RMDs on time
Here's one of the most important things to know about RMDs: They feature painful penalties if you take them late. Indeed, it's been reported that 6.7% of Vanguard customers failed to take an RMD on time, costing them up to $1.7 billion in penalties.
The penalty is currently 25% of the amount you failed to take on time. So if you needed to take out $8,000 and didn't do so on time, you're facing a $2,000 penalty!
3. Automate your withdrawals
One way to avoid being late is automating your withdrawals. Many good brokerages allow you to set up automatic annual withdrawals -- and they'll even calculate the correct RMD amount for you. (Still, it's not a bad idea to set a reminder in your calendar to double-check that the RMD was taken on time.)
4. Use them for everyday living expenses
So -- how might those in retirement best use their RMDs? Perhaps the most obvious way is simply for living expenses. Between Social Security benefits and other savings, many people will still have trouble getting by, so these withdrawals can certainly help.
5. Use RMDs for emergencies
It's smart for each of us to have an emergency fund, with enough accessible money to support you for at least three months, if not longer. It can be hard to accumulate that much money and park it in a separate fund, so when you get a big infusion of money via your RMD, you might just immediately move it into an emergency fund.
6. Pay down debts
Using your RMD to pay down debts, especially high-interest rate debt such as that from credit cards, is another smart move. Getting out of that kind of debt should be a priority, as it can be costly.
Imagine, for example, owing, say, $30,000 at a not-uncommon interest rate of 20%. That will cost you around $6,000 -- each year -- in interest alone.
7. Reinvest the money
If you're lucky enough to have enough income to support you in retirement without counting your RMDs, you might just take the money and reinvest it in a regular, taxable brokerage account.
You might even take your RMD in a special way -- called an "in-kind" withdrawal, where the financial institution that's home to your RMD-requiring account transfers securities to your taxable account. Be careful with that, though, as you need to make sure that one way or another, you have withdrawn the correct amount.
8. Let RMDs help you with a Roth conversion
A Roth IRA conversion, sometimes referred to as a "backdoor Roth IRA," lets you transfer tax-deferred savings -- such as from a traditional IRA or a traditional 401(k), to a Roth account -- which offers tax-free retirement withdrawals if you follow the rules. Whatever sum you convert becomes taxable income to you, though.
Enter your RMD. If you do a large Roth conversion, you may be facing significantly increased taxes, so you might use your RMD to help pay for that.
9. Let them help you lower your taxes
Finally, you might use your RMD to help reduce your tax bill -- by donating the money. An effective way to do so is via a qualified charitable distribution (QCD). With a QCD, you direct your RMD to be sent directly to a qualifying charity. Doing so means you avoid being taxed on the RMD.
Speaking of taxes, if you do receive your RMD and face a bigger tax bill due to it, remember that you might engage in some tax-loss harvesting, where you sell some underwater holdings and apply those losses to offset taxable gains. You can then buy those investments back later, if you want -- but only after 31 days, for the strategy to work.
So consider using some of these strategies -- and whatever you do, be sure you're not late taking your RMD.
