In the year that a required minimum distribution (RMD) is due from a 401(k), IRA or other pre-tax retirement account, you’re required to withdraw a certain amount and pay your taxes due to avoid a 50% penalty. But that doesn’t mean there’s nothing you can do about this, and the associated taxes. With proper planning, you can absolutely reduce or even eliminate the impact of minimum distributions.
Here’s how to think about it. And if you want a professional to guide you through an appropriate strategy, you can get matched with a financial advisor for free.
What Are Required Minimum Distributions
A required minimum distribution (RMD) is a rule that applies to pre-tax retirement portfolios such as 401(k), 403(b) and IRA plans. There are no required minimum distributions for taxed portfolios or for any post-tax Roth accounts. This is relatively new as, prior to 2024, the RMD rule applied to Roth 401(k) and Roth 403(b) portfolios. This has ended as of 2024.
The RMD rule requires you to eventually begin withdrawing funds from all applicable pre-tax portfolios. Beginning at age 73, you must withdraw a minimum amount from each pre-tax portfolio by the end of the year. You can withdraw this money in any increments and at any time, so long as you take out the full value by December 31.
This rule applies separately to each applicable pre-tax portfolio. For example, say that you have a 401(k) and a traditional IRA. Each portfolio will have its own minimum distribution.
You can freely withdraw more than the minimum amount. You can also broadly use this money as you see fit, including reinvesting it in a taxed portfolio, although you cannot reinvest a minimum distribution withdrawal in a Roth IRA.
When you withdraw this money, as always with a pre-tax portfolio, you will pay income taxes on it. This is the purpose of minimum distributions, since the IRS wants to make sure you eventually pay some taxes on a pre-tax portfolio.
If you do not take the minimum distribution from any given portfolio, you generally will be charged a 50% excise tax on the amount not taken. For example, say that you under-draw your account by $5,000. The IRS may charge you up to $2,500 in taxes on that error. If you do make a mistake, in some situations the IRS can waive some tax penalties. This is most common if you voluntarily report and correct your mistake, and if it was good-faith error.
How Required Minimum Distributions Are Calculated
Required minimum distributions work on two deadlines:
First, for the year in which you turn 73, you have until April 1 of the following year to take that year’s distribution. For example, say that you turn 73 in 2024. You must take a minimum distribution for 2024, and have until April 1, 2025 to withdraw it. Under some occasional circumstances this can change for employer-sponsored retirement plans.
Second, for all subsequent years you have until December 31 to take that year’s full distribution. For your first year’s minimum distribution, this can mean doubling up your withdrawal in one year. In our example above, say, you could end up taking a withdrawal on March 31, 2025 and December 30, 2025.
For each year, for each pre-tax account, the minimum distribution is calculated as: the account balance as of the end of the previous calendar year divided by your uniform lifetime distribution period.
The distribution period is a value set based on your age and marital status. It is published in a series of tables by the IRS. It declines for each year of age, proportionally increasing your RMD requirements as you get older.
For example, say that you are 75 and unmarried. On December 31 of last year you had an IRA with $500,000 in it. Your RMD would be:
- RMD = End of Year Balance / Uniform Distribution Period
- RMD = $500,000 / 24.6
- RMD = $20,325
You must withdraw at least $20,325 from this IRA by December 31 of this year.
A financial advisor can help you calculate your RMDs and see how they affect your retirement income. Get matched for free.
Can You Reduce Your Required Minimum Distributions?
All of this takes us back around to this article’s headline question. How can you reduce your required minimum distributions? And, specifically, how can you reduce the associated tax impact?
There are two answers to this question.
First, for the year in which an RMD is due, there is little you can do to reduce your obligations. Your minimum distribution is required and calculated on January 1 of each year as of portfolio values for December 31 for the year prior. You must withdraw at least this amount.
Second, you can reduce your future RMD requirements with advanced planning.
Some of the most effective ways to approach this include:
Make a Qualified Charitable Distribution
To the extent that you must withdraw this money, you can manage your tax position with what is called a “Qualified Charitable Distribution.” (QCD) With a QCD, you transfer cash or assets from your pre-tax portfolio directly to a qualified charity. Your donation does not count as taxable income, and it does count toward your minimum distribution for the year.
The IRS caps the amount annual QCDs, with 2024’s maximum set at $105,000.
From an immediate perspective, a qualified charitable distribution does leave you financially poorer. While you don’t pay taxes on this money, you also don’t keep the rest (as opposed to with a distribution, where you keep the after-tax portion of your withdrawal). However, since this doesn’t count as taxable income at all, it does keep your overall tax bracket down, which can help reduce the taxes you pay on other income and assets.
Make a Roth Conversion
Assets held in a Roth IRA are not subject to minimum distributions or taxes. As a result, by converting pre-tax assets to a Roth IRA, you will eliminate your RMD requirements on the amount that you convert. You can convert eligible assets at any age and in any amount. The only significant restriction is that you cannot put RMD withdrawals into a Roth IRA.
In the year that you make a Roth conversion, you must pay income taxes on the full amount that you convert. The typical approach to this is to stagger your conversions, which can reduce each year’s bracket and associated tax rates. However, if you are currently concerned about RMDs, this will require striking a balance.
The more that you convert in a single year, the higher you will push your rates and the more you will pay in conversion taxes overall. However, the faster you convert your assets to a Roth portfolio, the less you will have to take in minimum distributions. Each year that you stagger your conversions is another year that you may need to take RMDs. However, you do have to let any money converted for five years in the Roth IRA before withdrawing it to avoid penalties.
All of this said, for many retirees a Roth conversion will not help protect their money. When you make a Roth conversion, you withdraw money from your pre-tax portfolio and pay taxes on the amount taken. If your goal is to avoid RMDs, which force you to withdraw money from your pre-tax portfolio and pay taxes on it, then a mid-retirement conversion may defeat the entire purpose. This is often best used as a tool for future retirement planning instead.
Roth IRA conversions can get tricky and often have significant and immediate tax consequences. It may be best to talk to a professional fiduciary advisor before executing a plan.
Structure Your Distributions
A good way to manage your long-term RMD requirements is to structure your withdrawals across different accounts. Specifically, look to take income from your pre-tax portfolios first. This will reduce the value of your portfolios subject to minimum distributions, allowing your other assets to maximize their growth in the early years of your retirement. For example, if you have both a 401(k) and a Roth IRA, take money from your 401(k) first, and take income from your Roth IRA later in retirement.
If you choose, you can maximize the value of this approach by starting to withdraw assets from your pre-tax portfolios at age 59 1/2 (the earliest you can generally do so without penalty). You can move those assets into a taxed portfolio, which is not subject to minimum distributions. Although, as with Roth conversions, this is a tradeoff. By withdrawing money from your pre-tax portfolios earlier, you will reduce your long-term exposure to minimum distributions. However you will also sacrifice the tax-deferred growth those portfolios enjoy, potentially reducing your overall post-tax financial position.
Invest In Annuities
Finally, you can restructure your investments around annuities.
While this rule has some complications and exceptions, in general you do not have to calculate minimum distributions for an annuity. More specifically, the income that your annuity generates is subject to income taxes unless it is part of a Roth portfolio. That income and the associated taxes are considered to satisfy any RMD requirements for a pre-tax portfolio. This is not a hard and fast rule, but it will work for most households.
A financial advisor can help you determine the proper annuity products to avoid RMDs and suit your needs.
The Bottom Line
Required minimum distributions are the amount that you must withdraw every year from each pre-tax retirement portfolio that you own. While you cannot reduce your withdrawal requirements for the current year, you can restructure your RMD requirements for future years.
Tips For Investing Around Your RMDs
- This is a subject with a lot of different strategies and options. If you’re looking to manage your RMDs, our strategies here will help. And here are another six strategies for managing your minimum distributions long term.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/Fly View Productions