Changes in RMDs: What should you consider?

You may have spent decades contributing to your traditional IRA and 401(k) or similar employer-sponsored plan – so when it's time to tap into them, you'll want to manage your withdrawals carefully.

Once you turn 73, you generally must start taking withdrawals – called required minimum distributions, or RMDs – from your traditional IRA and your 401(k) or employer-sponsored plan. Your age and account balance determine your RMD each year. This year, the IRS life expectancy tables have been updated to reflect longer life spans – which may result in lower annual RMDs.

Lower RMDs can potentially benefit you in a few different ways. Because your withdrawals are generally taxable at your individual tax rate, the lower your RMDs, the lower your tax bill might be. And smaller RMDs will take a smaller “bite” out of your retirement accounts, allowing them to grow tax deferred for longer.

Furthermore, lower RMDs may give you more control over your retirement income planning. By definition, "requirements" take away some of your freedom. RMDs require you to take a certain amount regardless of whether you need it. In fact, if you withdraw less than the required minimum, the amount not withdrawn will be taxed at 25%. Reducing those requirements can give you more flexibility. And you’re always free to withdraw more than the required minimum.

Strategies for managing RMDs

While the potentially lower RMDs may prove helpful, you might also look for other ways to help manage withdrawals, especially if you don't need them to meet your retirement income needs. Here are a few suggestions:

• Defer RMDs through employment. If you’re still working and don't own more than 5% of the company, you typically don't have to take withdrawals from your current employer’s plan. You might also be able to roll over old 401(k)s and traditional IRAs to your current employer’s plan, and, by doing so, defer required distributions on those balances until you’re no longer working.
   
• Roll your Roth 401(k) or similar employer-sponsored plan into a Roth IRA. Many employers offer a Roth option, in which employees contribute after-tax, rather than pretax, dollars to their plan. Earnings and withdrawals from a Roth 401(k), like those of a Roth IRA, are tax free, provided you’ve had your account at least five years and you don’t start withdrawals until you’re 59½. However, Roth 401(k)s are subject to RMDs (if you're no longer working for the employer), while Roth IRAs are not. So, you could potentially eliminate those RMDs by rolling over your Roth 401(k) to a Roth IRA. (Keep in mind, though, that if you open a new Roth IRA to accept 401(k) rollover funds, you may incur a 10% tax penalty on the earnings portion – not the contributions – if you take withdrawals before five years have passed. But if you roll over a Roth 401(k) to a Roth IRA that you’ve had for at least five years, and you’re 59½ or older, you can take tax-free withdrawals immediately.)
   
• Take a qualified charitable distribution (QCD). If you’re at least 70½, you can make a qualified charitable distribution (QCD), which involves moving money directly from your traditional IRA to a qualified charity. By taking a QCD, you can satisfy some, or possibly all, of your RMD for the year, and you can exclude them from your taxable income, which may reduce your income taxes. (The maximum amount of QCDs that can be excluded is $100,000 per taxpayer per year.)
   
• Consider a Roth IRA conversion. Over the years, you may have accumulated large sums of money in a traditional IRA or a 401(k), and your RMDs may be substantial, especially in your later retirement years. Roth IRAs, on the other hand, are not subject to RMDs. Depending on your tax situation, you may want to consider converting a portion of your traditional retirement accounts each year to more effectively manage your income throughout retirement.

Roth IRAs also offer the benefit of tax-free earnings if you’re 59½ or older and you’ve had your account at least five years, so this strategy might be especially valuable if you plan to leave some of your Roth IRA assets to your heirs. However, when converting assets from your traditional IRA or 401(k), you’ll typically need to pay taxes on the converted funds in the year of conversion. As a result, you should consult a tax professional before making any moves.

One final thought: If you’re considering a rollover or conversion strategy, keep in mind that you can’t roll or convert any RMDs in the year they're due – in other words, you must accept the RMD amount due that year. Traditional IRA and 401(k) balances above the RMD amount can be rolled over or converted.

Factor RMDs into your plans

You might benefit from the potentially lower RMDs resulting from changes in the life expectancy tables. And the options for managing your RMDs, described above, may also prove useful. But in any case, you’ll probably need to factor RMDs into your retirement income plans for many years to come. Your financial advisor, along with your tax professional, can help you choose the RMD-related moves that are appropriate for your needs.