3 Ways to Reduce Taxes on Required Minimum Distributions (RMDs)

How can you reduce taxes on your Required Minimum Distributions (RMDs) from retirement accounts?

If you have a 401k or IRA, you will eventually be forced to take out a Required Minimum Distribution, also known as an “RMD.” This is a mandatory distribution amount that you are required to take from your retirement accounts, such as a 401k or IRA, before the end of each year once you reach a certain age. Why are you forced to take out this amount each year you may ask? Well, it is a way for the IRS to collect income tax on your retirement accounts instead of just indefinitely letting it grow... Unless you have a Roth IRA, the contributions made into your 401k or IRA have never been taxed, and now the IRS wants you to pay taxes on those contributions… and the earnings.

A couple questions we often get asked by clients:

1)?How do you calculate the RMD each year? You use a number based on your age from the IRS life expectancy table, as well as the account balance at the end of the previous year.

2) What happens if you don’t satisfy your RMD? Well, you would be hit with a 25% tax penalty (it used to be 50%, but the SECURE Act 2.0 that was passed this year lowered that penalty).

Our firm, The Clark Group Asset Management, helps calculate this number for all of our clients each year and confirm that our clients are satisfying their RMDs. Due to the SECURE Act 2.0, the age for required minimum distributions (RMDs) from an IRA has increased to 73 effective on January 1, 2023, and again to 75 starting on January 1, 2033. (IRA owners turning age 72 in 2023 would not be required to take RMDs in 2023.)

Now, some of our clients don’t necessarily need to take out funds from their retirement accounts. They have pension income streams, social security, rental income, and other retirement buckets such as taxable trust accounts, whereby they live comfortably off of those buckets. What we typically do for these individuals and families is create tax strategies to help them with their RMDs. If a client does not need the funds or don't want it sitting in a checking or savings account, we typically will reinvest our client’s net (after-tax) RMD amount into a taxable brokerage account, so that their funds can continue to grow with a diversified allocation of stocks, bonds, and potentially alternatives. Yes, they still have to pay income tax on the distribution from the IRA or 401k, but thereafter, all of the growth or appreciation is usually taxed at a much more favorable long-term capital gains tax rate. But what other ways can you lower your taxes and potentially eliminate taxation entirely on RMDs? Below I highlight 3 tax strategies we implement for clients:

1)?Charitable Donations: If you regularly make charitable contributions, you can consider using qualified charitable distributions (QCDs) from your IRA to satisfy your annual RMDs. QCDs allow individuals aged 70? or older to transfer up to $100,000 per year directly from their IRA to a qualified charity. This distribution is NOT included in your taxable income and can satisfy your RMD requirements. In our eyes, this is an excellent strategy if you are somebody who enjoys being charitable or generous with their money, and do not want to pay taxes on their RMD.

2)?Roth Conversion: Consider converting some or all of your traditional IRA funds into a Roth IRA. While this conversion will trigger an immediate tax liability, future qualified withdrawals from the Roth IRA, including RMDs, are tax-free. By converting before reaching RMD age, you may be able to minimize taxes on distributions later. This is also an excellent tool for generational planning purposes. Once your non-spouse beneficiaries (ex. children) inherit your retirement accounts, they are forced to deplete the account within 10 years while ALSO being forced to take out an RMD each year within that 10-year window. If you convert your IRA to a Roth before you take out RMDs, not only are you avoiding the RMD taxation, but when your children inherit the funds, they do not have to pay taxes on the distributions. Instead of doing a Roth conversion all at once, we typically like to do a laddered approach over the course of a few years to lower the tax burden each year.

3) One-time, split-interest election: Section 307 includes a one-time election for a QCD to a split-interest entity. This indicates an ability for donors to make a QCD of up to $50,000 to fund one of either a Charitable Remainder Unitrust (CRUT), Charitable Remainder Annuity Trust (CRAT) or Charitable Gift Annuity (CGA). Further, the SECURE Act 2.0 allows a donor 70.5 or older to transfer a QCD of up to $50,000 from a traditional IRA to a "split-interest entity" that will pay a fixed percentage (minimum 5%) for life to the donor and/or donor's spouse. A split-interest entity may be a charitable remainder unitrust, charitable remainder annuity trust or charitable gift annuity. The transfer does not qualify for a charitable contribution deduction, but it also does not cause the donor to recognize income on the rollover and allows the donor to satisfy all or part of the donor's RMD.

These are a few options that we utilize for our clients. If you would like to learn further about any of these strategies, or tax planning approaches for your retirement accounts, please reach out to us.

For important disclosure, please visit: clarkgroupam.com/disclosure

Sources: https://www.schwab.com/learn/story/rmd-strategies-to-help-ease-your-tax-burden