Although you may not have heard of them, Required Minimum Distributions (RMDs) should be one of the building blocks for your retirement planning. Planning around RMDs allows you to better allocate savings between your Roth IRA, Traditional IRA, Traditional 401(k), and Roth 401(k). This may seem like an odd place to start, but I believe that you need to know where you’re going before you plan how you will get there.
What are Required Minimum Distributions?
Since you are not allowed to keep your retirement savings in your accounts indefinitely, except for a Roth IRA, you are required to start taking distributions from these tax deferred accounts once you reach age 70.5 (Happy Half Birthday from the IRS!). You must take your first distribution by April 1st of the year following the calendar year in which you reach age 70.5. You may be thinking that you are way too young to worry about what will happen when you are over 70, but by planning now you can possibly avoid a lot of taxes.
How are they calculated?
RMDs are calculated by taking the account balance as of the end of the immediately preceding calendar year, and dividing that by a distribution period from the IRS’s Uniform Lifetime Table. If you have an account balance of $100,000 and a life expectancy of 10 more years, you are required to take out at least $10,000.
Is there any way to postpone them?
As long as you are still contributing to your 401(k) you can postpone the withdrawals until the year after you retire, however you will still have to take RMDs from any Traditional IRAs or other like accounts. This may seem like a good idea, but this becomes a tax problem as your balance continues to increase while your life expectancy continues to decrease. This causes an increase in your RMDs over the following years.
What accounts are used to calculate my total balance?
The distribution rules apply to: Traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k) plans, 403(b) plans, 457(b) plans, profit sharing plans, other defined contribution plans. The exclusion from this list is one of the reasons that a Roth IRA is highly recommended.
Why can RMDs be a problem?
In our simple example, a distribution of $10,000 is not so terrible since you will remain in a low tax bracket. If we change the scenario to having an RMD of $500,000, we see that according to 2016 tax rates there will be a portion of that money that is taxed at the highest rate. This gives us incentive to smooth our distributions out to try to avoid being in the highest tax bracket.
How can we avoid our RMDs reaching the highest tax bracket?
There are three important steps that can help to avoid being pushed into the highest tax bracket with your RMDs. The first is to make sure that your assets are correctly located. This will give your overall investment portfolio the same expected return, but the lower returning fixed income assets will be in your pre-tax savings vehicles. The second is to contribute to post-tax vehicles while your tax bracket is still below what it would be in retirement. This takes some lengthy forecasting, I personally choose the 28% tax bracket and lower, but your choice may be different depending on your projected future income. The third step is to do strategic Roth conversions before you are required to take a distribution. This will give you a lower overall balance by the date of your first required distribution, lowering the amount of money that could be taxed at the highest rate. This may also require you to delay your social security payments which may provide a very nice guaranteed rate of return from the government.