There's a reason why 401(k) and individual retirement accounts are called "tax deferred." You pay no taxes while you're accumulating savings, but Uncle Sam ultimately gets his bite when funds are withdrawn. And to make sure the meal gets started on time, you'll face though the dreaded required minimum distribution (RMD).
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RMDs must be taken from IRAs starting in the year you turn 70.5 - and from 401(k)s at the same age, unless you're still working for the employer that sponsors the plan. They exist to make sure the tax benefits of these accounts don't extend indefinitely - and that you start using these assets, and start paying taxes, in retirement.
"RMDs are a double straitjacket," says Christine Fahlund , senior financial planner and vice president of T. Rowe Price Investment Services. "First, the government requires you to pull money out of your accounts when you don't necessarily want to, and then you're required to pay taxes on the withdrawals."
Like it or not, this is the time of year to think about RMDs, since in most cases they must be taken by Dec. 31. And it's important to get this right: Failure to take the correct distribution results in an onerous 50 percent tax - plus interest - on any required withdrawals you fail to take.
RMDS can boost other expenses, too. Since distributions count as ordinary income, they can push you into a higher tax bracket. They also can trigger higher taxes on Social Security benefits and substantial high-income surcharges on Medicare premiums.
Here are year-end tips from the pros on effective RMD management.
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DO THE MATH, CHECK THE CALENDAR
RMDs must be calculated for each account you own by dividing the prior Dec. 31 balance with a life expectancy factor that you can find in IRS Publication 590 (). Often, your account provider will calculate RMDs for you - but the final responsibility is yours. FINRA, the financial services self-regulatory agency, offers a calculator (), and the IRS offers worksheets () to help calculate RMDs.
RMDs must be taken by year-end, with one exception. If you turn 70.5 this year, you have until next April 1 to take your 2013 RMD. However, doing that means you'll be taking two distributions in 2014 - which could have a significant impact on your income taxes.
Although RMDs are calculated for each IRA you own, you don't have to take a separate distribution from every account. You could total up your RMDs and take it all from one IRA - one that is a poor performer, perhaps, or one that will help you rebalance an account that might be overweight in equities against your overall allocation plan.
"It's a great idea to use RMDs to restore balance to your portfolio," says Christine Benz, director of personal finance at Morningstar. "We've seen a tremendous run in stocks, recent losses notwithstanding, so it's a good bet that many retirees' equity allocations are above their target ranges."
With 401(k)s or other workplace plans, the RMD must be taken from each individual account you own. If you've left a trail of 401(k)s at various jobs over the years, that can be a chore - and a good argument for consolidation, argues Fahlund. "If you're just getting into the world of RMDs, it's a good time to consolidate your 401(k)s and IRAs," she says. "Minimize the number of accounts you have, so you can keep track of them more easily."
AVOIDING TAX SHOCKS
It's bad enough that RMDs may force you to sell assets you might prefer to hold. But RMDs also can trigger an increase in income taxes if they push you into a higher bracket.
Another bummer: RMDs can mean a bigger tax on Social Security benefits, which are taxed using a complex "provisional income" formula that is determined by adding together your adjusted gross income, tax-exempt income and half your Social Security benefit.
If you're over age 70.5, options for minimizing RMDs are few. One that is available - at least this year - is the qualified charitable distribution (QCD), which lets you make cash donations up to $100,000 to IRS-approved public charities direct from an IRA. (QDCs from workplace plans aren't allowed.) The gifts can be counted toward an RMD and are excluded from your taxable income.
This tax shelter has been on the congressional chopping block for some time and isn't expected to be extended for 2014. "It's the most interesting option this year, if you're in a position where you don't need the money yourself and you're charitably minded," says Jeremy S. Elliott, managing director at National Financial Partners.
Another option is converting IRAs assets to an after-tax Roth IRA. You'll owe income tax on the money you switch into the account in the year of the conversion, but you won't need to take RMDs in future years (though any beneficiaries would need to take RMDs down the road).
Finally, consider accelerating drawdowns from tax-deferred accounts before you enter the world of RMDs. Savings can be withdrawn without penalty from tax-qualified accounts after you turn 59. That will leave you with smaller tax-deferred accounts down the road - hence smaller RMDs.
Bill Meyer, co-founder of SocialSecuritySolutions.com, suggests taking distributions as large as possible so long as they don't push income into a higher tax bracket. "The idea is simple, he says. "If you reduce your RMDs down the road, you will have more money to spend in retirement."