How to Tax-Efficiently Manage RMDs
- Timing is vital when taking Required Minimum Distributions
- Three methods of tax-efficient planning
- Find more flexibility the further you are out from retirement
Professors across the country have been contributing to university-sponsored retirement plans for most of their careers. These plans allow tax-deferred contributions generally during the highest income earning years, and like Individual Retirement Accounts (IRAs), are eventually subject to Required Minimum Distributions (RMDs). After contributing over a 30+ year career, you may have required distributions in excess of your income needs, especially when combined with Social Security benefits. You could even be in the same or higher income tax bracket in retirement. No matter the stage of your academic career, there are opportunities for tax-efficient planning.
When do RMDs begin?
As of 2019, RMDs begin at age 72. The first distribution can be delayed until April 1st of the year after you turn 72, though that would mean taking two RMDs in one year.
RMDs are calculated based on the December 31st value of any applicable account. That value is divided by a factor based on age. This factor begins at 25.6 for age 72 and decreases each year thereafter. For example: if, on December 31, 2021, a retired professor has a 403(b) account balance of $1.75M and an IRA balance of $1M, her total 2022 RMD would be $107,421. ($68K from the 403(b) and $39K from the IRA.) She would have until April 1, 2023 (the first year of her RMDs) to withdraw this amount and it would be fully taxable in the year of distribution. If the distribution is not taken, the IRS assesses a penalty of 50% of the amount that should have been withdrawn. With Social Security and assuming the standard deduction, this professor would easily be in the 24% Federal tax bracket and potentially higher if there are other sources of income.
Save Money on Income Taxes with Tax-Efficient Planning
- Charitable Giving: Offset Your Income Dollar-for-Dollar
There are multiple options to plan for RMDs tax-efficiently. If charitably inclined, you can donate directly from an IRA. This reduces your taxable income efficiently, especially if the standard deduction would otherwise be used. Specifically, efficiency may be gained from the ages of 70½ to 72. While RMDs now start at 72, the ability to contribute directly to charity from an IRA stayed at 70½. This reduces the overall account balance subject to RMDs and frees up any cash flow normally used for charitable giving.
- A Family Affair: Pay Lower Taxes Today, Not Higher Taxes Tomorrow
Think of RMD assets from a multi-generational approach: RMDs apply not only to the current account holder, but also to any beneficiaries. Non-spouse beneficiaries of an inherited account have a 10-year window to fully withdraw funds. If a professor has children in a similar tax bracket or higher than his own, he may consider taking distributions in excess of the RMD each year, thereby paying the tax at his current lower rate than what may be paid by beneficiaries in the future. This can be either a taxable distribution or a Roth conversion.
- Early Withdrawals: Reduce Balances Subject to Future RMDs
Similar opportunities are available for those who retire before RMDs begin. Withdrawals from IRAs and employer plans can begin as early as age 59½. If projected RMDs will provide more income than needed at age 72, consider “tax bracket planning.” Take distributions now at your current tax rate, especially if projected RMDs lead to a higher bracket in the future. Repositioning these assets via taxable distributions or a Roth conversion reduces the balances applicable to RMDs in the future.
More Time Means More Flexibility
Tax efficiency and flexibility are easiest for those with many years to retirement. If working beyond age 72, look at consolidating retirement accounts into your employer plan. Assets in an employer plan are not subject to RMDs if you are still working for that employer.
Traditionally, pre-tax contributions to employer retirement plans meant deferring income when your tax rate is high and receiving distributions when your tax rate is lower. This may not be as probable going forward. With currently low tax rates and a growing deficit, tax rates may need to increase in the future to compensate, leaving you with less real money in your pocket.
Most university plans now allow for after-tax Roth contributions. This is available to all participants, regardless of income level. Contributing to the Roth options will allow for tax-free growth and, ultimately, tax-free distributions in retirement. The best part: unlike Traditional IRAs, dollars in a Roth IRA are not subject to Required Minimum Distributions. A custom combination of these methods is best to tax-efficiently manage your RMDs.