The year you turn 70 ½, you reach a milestone in your retirement. At that age, required minimum distributions (RMDs) kick in, which is when you must begin making mandatory withdrawals, or distributions, from your IRA accounts (and employer-sponsored plans). These distributions are required even if you don’t need the money to pay your expenses.
Because RMDs count as income, they could boost you into a higher income tax bracket or even make your Social Security benefits taxable, if they weren’t before. This is a real challenge, given that income taxes are often the single biggest expense for retirees.
Fortunately, advance planning can take the sting out of RMDs. In fact, you could look at RMDs as an unexpected opportunity when designing a tax-smart retirement withdrawal plan.
RMDs in action
Let’s consider an example of a retiree with $1 million in her IRA accounts who will turn 70 ½ in 2012. Under existing rules, she must take her first RMD by April 1, 2013, based on her IRA balance at the end of 2011. Her RMD would be roughly $36,500. But she also has to take her second distribution by Dec. 31, 2013, based on the total IRA balance at the end of 2012.
If she follows the natural inclination to delay her first RMD until April 1, 2013, it could make her tax situation worse. She would then receive two distributions in the same year. This extra income would most likely boost her into a higher tax bracket and potentially cause her to pay higher Medicare Parts B and D premiums. It might also expose more of her income to the new 3.8 percent Medicare tax, which will take effect in 2013.
Meet the RMD challenge
Though you face mandatory distributions at age 70 ½, you don’t have to wait until then to find the best strategy for you.
One option you have is to withdraw money from your IRA before the distributions are required. For example, a retired couple in their 60s could withdraw just enough from their IRA to keep within their 15 percent or 25 percent income tax bracket.* They could use that money to pay for living expenses rather than drawing Social Security. Delaying the start of Social Security benefits will not only result in a higher benefit payment when you do start, but may also lower your income taxes in retirement.
Up until Dec. 31, 2011, another way to lower potential RMDs in retirement was to make gifts of up to $100,000 from your IRA to your favorite qualified charity. These distributions would not increase your gross income. This may be an option again in the future, as some Congressional leaders hope to pass a retroactive extension of this tax provision.
A third method is to convert a traditional IRA to a Roth IRA, which is not subject to mandatory distributions. Some people have concerns about Roth IRAs because you pay taxes on the amount of the conversion in the year you make the conversion. Keep in mind, though, that once you’re over this hump, distributions from your Roth IRA are generally not taxed.* And Roth IRA assets can grow tax-free, even beyond the owner’s death.
Avoid RMD surprises
Planning for the potential consequences of RMDs long before you have to deal with them can help keep your Social Security benefits out of the income tax stream and shift your income from a higher to a lower tax bracket. If you are nearing retirement, discuss your Social Security and long-term tax planning opportunities with a financial planner.
* If you are contemplating withdrawing retirement funds before age 59 ½, remember that retirement accounts have regulations and tax penalties that may apply to early withdrawal.
Erin Eddins is a Chartered Financial Consultant, a member of the Financial Planning Association and is a certified financial planner professional. She can be reached at erin.eddins@standard.com or 425-212-5986.
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