What if I don’t need my required minimum distribution (RMD)?

Reader Question:

Basics of Required Minimum Distributions (RMDs)

You were likely encouraged to build up savings into various tax-deferred retirement accounts during your working years. When you contribute a portion of your wage income into a traditional pre-tax employer plan, you are electing to defer the payment of taxes on that income. In other words, you will not pay any ordinary income taxes on your contribution now, but you will pay taxes on any distributions from the account later on in retirement. This is true of contributions to any pre-tax types of retirement plans such as: 401ks, traditional Individual Retirement Accounts (IRAs), SEP IRAs, SIMPLE IRAs, 403(b)s, 457(b) plans and profit-sharing plans.

As you can imagine, the government does not allow you to keep the value in your retirement accounts indefinitely without paying some form of tax on the value. You eventually have to start taking annual withdrawals from the account- this is known as a required minimum distribution (RMD). Your RMD is the minimum amount that you must withdraw from your account each year.

The starting age for RMDs was changed as of December 2022 with the passage of the Secure Act 2.0. Prior to 2023, the starting age for RMDs was 72, from 2023-2032 the starting age has been moved up to 73 and starting in 2033 it will be adjusted up to 75. You are required to take your very first RMD as of April 1 of the year following the calendar year in which you reach age 73. You must then take one every year thereafter.

It might sound unfair that you are required to take a certain minimum withdrawal from your account every year- what if your account value is down in a bad market year? Your RMD is not a fixed amount as it is re-calculated annually after you reach RMD age (currently 73). The value is calculated by taking your retirement account balance as of December 31 from the prior year and dividing by a life expectancy factor published by the IRS. You can find the current life expectancy tables through the IRS website.

For example, if you are turning 73 this year and had a $1,000,000 IRA as of December 31, 2022, then you would be required to do an initial RMD of $36,497 ($1 ML /27.4).

Taking these distributions is not merely a suggestion as the name “required” implies. If you fail to take your RMD or do not take the full amount, the IRS will assess a penalty of 50% for the amount not taken in time. In our example, this would be a penalty of $18,248 on top of the actual required distribution.

What to consider if you will not need your RMD

Some people will need the entire value of an RMD as part of their retirement income to pay for regular living expenses. In fact, many people will distribute funds from retirement accounts prior to RMD age or take more than their RMD after reaching RMD age in order to meet their spending needs. However, what if you do not need some or all of your RMD for your retirement spending? Taking an IRA distribution larger than you actually need can end up increasing your taxable income enough to move you into a higher ordinary income tax rate, increase the taxation of your Social Security benefit and/or increase your Medicare premium. These additional taxes and expenses can really impact your retirement money and financial situation. Check out our article on how the increase to your Medicare premium works-otherwise known as IRMAA.

Below are some of the key strategies to consider, either before or after you reach RMD age, if you anticipate that you will not need your RMD to fund your living expenses:

Planning Ahead- Roth Conversions

Perhaps you are nearing retirement with a sizable pre-tax retirement account and several years away from age 73. First of all, congratulations on doing a great job of saving during your working years. However, you may be faced with sizeable RMDs above what you will need depending on your other assets and fixed income. The good news is that there is a proactive planning strategy that can help reduce RMDs (and thus your tax burden) along with create value in a tax favorable account.

This strategy- known as a Roth conversion- allows you to move traditional IRA money into an even more tax favorable account known as a Roth IRA. Roth IRAs hold money that you have already paid taxes on and provide tax-free growth and distributions as long as holding requirements are followed. They are also not subject to RMDs (unlike traditional IRAs). Completing Roth conversions after your income has dropped in retirement and you are at a lower tax bracket, but before RMD age, allows you to pay some taxes on the conversion funds at a lower rate and keep the money invested in a Roth for longer-term needs. It also shrinks your traditional IRA account balance, which will reduce the value of your RMDs when you reach age 73.

Typically, Roth conversions are a good strategy to consider when you have other sources of retirement income (ex. Pension or Social Security benefits) or assets (ex. taxable brokerage account) to live on while completing conversions and you anticipate that your RMDs will be more income than you need. For those who have children, Roth IRAs are also a much more favorable inheritance vehicle than traditional IRAs. When an adult child inherits a Roth IRA, they will need to do RMDs but they will not pay any tax on these distributions unlike with a traditional IRA.

Building up savings or taxable investment accounts

Although you are required to take your RMD, there is no rule saying you need to spend the RMD. You can turn right back around and invest the RMD in a taxable brokerage account. Although these accounts do generate taxable investment income during the year (unlike a 401k, traditional IRA or Roth IRA), people are typically at a fairly low tax bracket during retirement and with tax-efficient investment strategies you can help keep the investment income taxes as minimal as possible.

If you have some nearer term big expenses (a car replacement, big trip, etc.), you could instead elect to move the RMD into a high yield savings account. This will keep your money liquid, but will at least allow you to earn some interest until you need the funds.

Charitable Planning- Qualified Charitable Distributions

Perhaps you enjoy giving to one or several charities throughout the year. If that sounds like you, Qualified Charitable Distributions (QCDs) are a great option for you to consider as long as you meet the age requirements. A QCD allows you to complete a tax-free distribution from your IRA as long as it is made out directly to a qualified charity. These distributions count towards your RMD so you do not need to take out any additional funds as long as the QCD meets your entire RMD amount. QCDs are allowed after you turn 70.5 and you are allowed to complete a total of $100k in donations per year per person.

You may be thinking that you are also getting a benefit on your tax return when you do a regular donation that is not from your IRA. However, if you are one of the many people who end up taking the standard deduction every year, then you are actually not getting any tax benefit for your charitable contributions. A QCD allows you to get a tax benefit by avoiding paying any taxes on donations made directly from your IRA while also meeting your charitable giving goals. Check out our article on tax deductions and charitable giving for more information.

Gifting to Family

You may find in the course of your long-term planning that you are confident you will outlive your assets. In that case, you might consider using part or all of your RMD to fund gifts to your children or other family members. The current gift tax exclusion limit is $17,000 per person. This means you can gift someone up to $17,000 without having to report the gift to the IRS and have it count towards your lifetime exclusion. Keep in mind the limit is per person, so for a couple gifting to their adult child, they can gift up to $34,000 and stay under the limit.

There are many strategies to consider if you think you may not need all or part of your required minimum distributions. We highly recommend reaching out to your financial advisor and tax advisor when considering these various strategies as she or he can help evaluate the best options for you as well as give more specific advice on the timing and quantity of a strategy such as a Roth conversion.

Liz Alf is the Principal of Clerestory Advisors and fee-only CERTIFIED FINANCIAL PLANNERTM located in Minneapolis, MN. She is a member of the National Association of Personal Financial Advisors (NAPFA) the Fee Only Network and Wealthtender. She enjoys serving clients with on-going financial planning and investment management services.