One of the most disliked aspects of retirement finances is dealing with required minimum distributions (RMD). Today’s article on how to avoid taxes on RMD is meant to help make them more bearable.
In this article:
- On Retirement Plans
- Tax Treatment of Roth IRA, Traditional IRA, 401(k), 403(b)
- Pre-Tax Dollars and RMD: Rules and Penalties
- How to Calculate RMD
How to Avoid Taxes on RMD | Rules and Strategies
On Retirement Plans
Saving for retirement is one of the most important things a person should do as early as possible. The earlier one starts saving up for it, the easier it becomes, and vice versa.
Prepping for retirement isn’t just about saving and investing money in assets like precious metals, stocks, and cryptocurrencies. It also requires good tax-minimizing management strategies because taxes can take substantial chunks out of one’s retirement finances.
That’s why one of the best ways to ramp up one’s retirement finances is by investing in retirement plans. This can help any person who’s preparing for retirement to minimize the potential effects of taxes on their retirement funds.
Some of the best retirement plans that provide retirement tax benefits include IRAs (Traditional and Roth), 401(k)s, and 403(b)s. These tax benefits are tax deferment and tax-exemption.
Tax Treatment of Roth IRA, Traditional IRA, 401(k), 403(b)
Roth IRAs Tax Treatment
However, note that only Roth IRAs provide tax exemption benefits upon retirement. With this retirement plan, there is no need to pay taxes on qualified withdrawals during retirement since the income from contributions for this type of IRA consists of post-tax dollars.
What are Post-Tax Dollar Contributions? These are contributions funded by income that was already taxed by the IRS. These contributions don’t qualify as tax-deductible expenses for the year.
Tax Treatment of Traditional IRAs, 401(k)s, 403(b)s
On the other hand, Traditional IRAs, 401(k)s, and 403(b)s provide tax deferment benefits prior to retirement. This means a person can use contributions to these funds or investments as qualified tax deductions for the year — pre-tax dollar contributions.
What are Pre-Tax Dollar Contributions? These are contributions funded by income that the IRS hasn’t taxed yet. These contributions qualify as tax-deductible expenses for the year.
Implications of Tax Treatment of Different Retirement Plans
The benefit of being able to use pre-tax dollars to fund certain retirement plans is that one can invest more money for retirement. This means higher potential growth and possibly more money during retirement.
However, there’s a potential disadvantage to investing in pre-tax dollar-funded plans like Traditional IRAs and 401(k)s. Withdrawals from these types of plans requires payment of income taxes, too.
For such types of retirement plans, it seems that the easiest way to avoid taxes on withdrawals is to avoid making them. Unfortunately, a person can only hold off making withdrawals from pre-tax dollar funded retirement plans for so long as the IRS eventually forces them to make withdrawals.
Pre-Tax Dollars and RMD: Rules and Penalties
Required Minimum Distribution Rules
More fondly referred to as “RMDs”, these are compulsory withdrawals that retirement plan owners need to make. RMDs only apply to retirement plans funded by pre-tax dollars like Traditional IRAs and 401(k)s.
- For Traditional IRAs, owners need to start making RMDs when they turn 70 ½ years old.
- For 401(k) owners, it’s 70 ½ years old or retirement, whichever comes later.
Plan owners who neither need nor want to make withdrawals have two tax-related issues with RMDs, which are:
- Higher taxes for the year since the RMD will be counted towards taxable income
- Losing the tax-deferred status of their investments
Penalties for Skipping RMDs
These issues can make it very tempting to skip RMDs but doing so can be very costly. How costly?
The IRS imposes a penalty of 50% of the amount of the RMD every time an investor fails to pay it. For example, a person with an $8,000 RMD will pay a $4,000 penalty if withdrawals for the year are less than $8,000.
How to Calculate RMD
Required minimum distributions aren’t flat across the board. The amount depends on two factors:
- Investor’s life expectancy
- Account balance
To calculate one’s total Traditional IRA RMD for the year, one must compute the RMD for each Traditional IRA account. To do this, divide the account’s previous year’s ending balance by a corresponding distribution factor.
The IRS determines this factor, the table of which is part of its IRA RMD worksheet. Once a person has calculated the RMDs for each Traditional IRA account, he or she must add them up to get the total Traditional IRA RMD.
Traditional IRA or 401(k) owners who neither need nor want to make annual RMDs from such plans have several options.
Option #1: Make a One-Time, Big-Time Rollover to a Roth IRA
A retirement plan owner can rollover balances from a Traditional IRA or a 401(k) to avoid paying taxes on withdrawals. However, this option has its advantages and disadvantages.
Disadvantage of Doing a One-Time Rollover
The disadvantage is that rolling over everything in one swoop means paying a potentially hefty one-time tax. Why?
The IRS taxes all withdrawals from Traditional IRAs and 401(k)s. The IRS considers transferring balances from such accounts to one that doesn’t require withdrawal taxes, such as a Roth IRA, as withdrawals.
Advantages of a One-Time Rollover
- There are two advantages to a lump-sum rollover, the first of which is that one won’t have to make RMDs anymore. The IRS doesn’t require minimum annual withdrawals from Roth IRA accounts.
- The other advantage is that the transferred funds can enjoy tax-free growth because the owners have already paid taxes on them. This is especially beneficial for plan owners in lower tax brackets with sufficient liquidity to pay the taxes immediately.
Option #2: Rollover Smaller Amounts to a Roth IRA over Several Years
The IRS considers withdrawals from any Traditional IRA or 401(k) account as taxable income. Thus, these can push any retirement plan owner up the tax-bracket ladder.
Advantages of Spreading Out Rollovers
- This option is ideal for those who don’t want to pay large taxes or aren’t liquid enough to do so. By rolling over smaller amounts from Traditional IRAs and 401(k)s across several years, one can minimize taxable income and taxes.
- The investor can start the rollover process fairly early, say, after turning 59 ½, and they can spread the entire rollover to a Roth IRA over 10 years instead of just one. By doing this, one can significantly reduce total withdrawal taxes by keeping a plan owner within the same tax bracket.
Disadvantages of Spreading Out Rollovers
- One disadvantage of this option is that it’s cumbersome. Instead of rolling over just once, one must repeat it over the next several years.
- Another trade-off is the potential for lower tax-free growth in the future.
- With a lump-sum rollover, the entire balance can start growing as soon as possible. Rolling over across many years means that the remaining balance in a Traditional IRA or 401(k) account will only start growing at a tax-free rate after rollovers.
This option can work best if completed before Social Security payments start coming in. Since the IRS considers Social Security payments as taxable income, scheduling the rollovers to coincide with these payments can push one up the tax-bracket ladder.
Many retirement plan owners consider required minimum distributions as burdens primarily because the IRS taxes them. This is especially burdensome for plan owners who neither need nor want to withdraw from their Traditional IRAs or 401(k)s.
Fortunately, these two options can help such retirement plan owners learn how to avoid taxes on RMD and, hopefully, help make their sunset years more enjoyable.
Which of the two options on how to avoid taxes on RMD do you prefer? Let us know in the comments section below!