Required minimum distributions are mandated (as the name implies) and taxed as ordinary income based on your current tax rate — the higher your income for the year, the higher your tax rate. However, you can have some control over the timing and size of your withdrawals, which can help you reduce your tax burden and keep more of your savings.
The RMD is calculated by dividing the account balance at the end of the prior year by an appropriate life expectancy factor. This factor decreases each year, meaning that as you divide the account balance by a smaller number, the percentage you are required to withdraw increases annually.
You are not responsible for these complicated calculations. For IRAs, the custodian will determine your RMD for the year and report that amount to the IRS. For 401(k)s, the account administrator generally handles RMD calculations and will report that figure to you. You are then responsible for withdrawing the correct amount each year. Failing to take your RMD by the deadline or withdrawing less than required could result in an IRS penalty.
Here are some ways to reduce the tax burden of your RMD.
Qualified charitable distributions. Money donated to a qualifying charitable organization through a QCD counts toward your RMDs and may reduce your taxes, as you can exclude the distribution from your income. The SECURE Act 2.0 limits the QCD to $100,000 per year, and it must be deducted from your account by Dec. 31 of any year. In some cases, a one-time QCD of $50,000 may be allowed through certain charitable remainder annuity trusts, charitable remainder unitrusts or charitable gift annuities.
Because your RMD is based in part on your account balances, converting to a Roth IRA (which is not subject to RMDs) can be beneficial. You will owe taxes on the amount you convert, effectively prepaying taxes by moving assets before the IRS requires you to take RMDs. This strategy is particularly advantageous in years when you have a lower income and are in a lower tax bracket; however, Roth conversions are available regardless of income level.
You can temporarily reduce RMDs with a qualified longevity annuity contract, a type of deferred income annuity. You can transfer up to $200,000 from a tax-deferred account into a deferred annuity that meets IRS requirements. The annuity company will convert that contribution into payments, which you can begin at any time up until you turn 85. Once you elect to receive payments, they will be treated as taxable income and will continue for the remainder of your life.
If you are still employed and own less than 5% of the company, you might be able to roll previous 401(k)s into your current 401(k), depending on your employer’s plan terms. This would allow you to delay RMDs until you actually retire.
You also have the option to use a portion of your RMD for tax withholding. This can help reduce what you owe in April and avoid underpayment penalties and interest. However, it leaves you with less immediate cash, particularly if you are unsure of your total tax liability. It’s wise to regularly review your income and deductions with a tax expert who can help determine the appropriate withholding amount.
Any strategy you choose will have its pros and cons. Be sure to review your situation with a CPA and a financial adviser before making any decisions.
