One of the realities of tax-advantaged retirement plans is that you eventually have to start withdrawing money from them. With the exception of Roth IRAs, you are required to receive distributions from your accounts each year once you reach a certain age – whether you need the money or not. That can have an impact on your tax bill, and you need to be ready for it.
What are Required Minimum Distributions?
Required Minimum Distributions (RMDs) represent the minimum amount you have to take from your tax-advantaged retirement account each year. Your RMD is based on how much money you have in your account, and your age. Generally, you are required to begin taking distributions the year after you turn 70½. The accounts that require RMDs are:
- Any IRA, except a Roth IRA
- Nearly all “qualified” employer-sponsored retirement plans. For most people, this means that 401(k) and 403(b) plans. Not that Roth 401(k) and Roth 403(b) plans also have RMDs.
You don’t have to withdraw a certain amount of money from a Roth IRA, or from a Section 457 plan, no matter how old you are. It is possible to put off withdrawals from 401(k) and 403(b) plans, however, if you still work for the company that sponsors the plan. In such cases, you can put off your RMDs until after you retire, even if you are beyond 70½. Realize, though, that any plan that isn’t sponsored will have RMDs. So, if you have a 401(k) through your current employer, as well as a traditional IRA, you can put off taking your RMDs from the 401(k), but you will have to start taking them from the traditional IRA.
What Happens with Your Taxes?
Once you begin taking withdrawals from your retirement account, you begin paying taxes on the income. The exceptions are Roth 401(k) and Roth 403(b) plans, since you put the money into these accounts post-tax, and the money grows tax-free. When you withdraw from your traditional 401(k) and 403(b) plans, though, you have to pay taxes on the income.
For some, this can be an undesirable turn of events. This is because the RMD might increase the amount of annual income that you have, and raise your taxes. In some cases, the start of RMDs can trigger a move into a higher tax bracket. Part of your financial planning in retirement should consider what you can do to minimize the impact of RMDs on your finances:
- Convert to an annuity: In some cases, converting your retirement account to an annuity with a regular payout can reduce the increases to RMDs that can come as you age. However, you do need to be careful about how you choose annuities since there are many annuity products that are problematic.
- Convert to a Roth IRA: Some retirees decide to convert or roll over their retirement accounts to a Roth IRA. That eliminates the need for RMDs. However, there is a tax consideration: You will have to pay taxes on the amount you convert (unless you converting from a Roth 401(k) and 403(b) to a Roth IRA).
No matter what you do, there will be tax consequences, so it’s important to consult with a tax planning professional who can help you figure out the best way to go about handling your RMDs so that you can reduce your tax liability as much as possible.