If you are a member in good standing of the middle class, if not wealthier, and are in relatively good health, there are many blessings about retirement.
You have a lot more free time to pursue hobbies and other pursuits, and paying for them is not a problem. You usually have relationships with grandchildren to foster and savor. If you have managed your retirement finances well, you have more freedom to spend on non-necessities because Medicare is inexpensive, your home is likely paid in full, and you have already put aside the necessary savings for retirement.
Unfortunately, one downside does emerge once you turn 70½ — the required payment of ordinary income taxes annually on a Required Minimum Distribution (RMD) from IRAs, 401(k)s and other tax-deferred retirement vehicles. These are not inexpensive. Required distributions from your IRA are 3.65% in your first year and rise each year thereafter. At age 75, the required distribution is 4.37%; at age 80 it is 5.35%.
This amounts to quite a bit of money even if your IRA is relatively modest. If you have an IRA worth, say, $500,000, you suddenly owe taxes on an additional $18,250. If you have a sizeable IRA worth, say, $3 million, you initially owe taxes on more than $100,000 in annual distributions.
Most people hate giving the government extra money, and in this case, there is seemingly no way out. Or is there? There are, in fact, five things you can do to mitigate the pain. They are:
- Move some of your IRA funds into a Roth IRA. In addition to shrinking the size of your IRA and, hence, your RMDs, the after-tax dollars you put in a Roth IRA produce tax-free earnings indefinitely. You do have to pay ordinary income taxes on funds transferred from an IRA to a Roth IRA, but this is money you would have to pay the government anyway if you live long enough. This way, you aren’t paying additional taxes later on at a potentially higher tax bracket.
- Purchase a deferred income annuity known as a Qualified Longevity Annuity Contract (QLAC). These allow individuals to reduce RMDs by purchasing a QLAC for $125,000 or for 25% of your retirement account balance, whichever is less, deferring the income up to age 85. Before the IRS authorized QLACs in 2014, the only real break available was the opportunity to delay your first RMD to April 1 of the year following your 70th birthday.
- Maximize withdrawals from your IRA prior to age 70½ to the level of peak earnings allowable within your tax bracket. Say, for example, you are married, file jointly and have $130,000 in annual adjusted gross income. That puts you in the 25% marginal federal tax bracket. You can earn up to $151,900 — or $21,900 more — and stay in the same tax bracket. You can do this if you withdraw the extra funds from your IRA, reducing future RMDs.
- Consider withdrawing even more money from IRAs for living expenses and leisure pursuits. This isn’t a problem for most retirees because they aren’t approaching a higher tax bracket. A general rule of thumb is that people can withdraw 4% of their IRAs and other retirement accounts annually in retirement and minimize the odds of running out of money. But you could increase that, say, to 6%, to lower future RMD fees and invest the extra money in tax-free municipal bonds or tax-deferred annuities and cash value life insurance policies.
- Make tax-free donations — known as qualified charitable distributions — of up to $100,000 directly from your IRA to a charity, sent by your custodian. Such a distribution doesn’t count as income. This eliminates your tax liability by the amount that goes to the charity.
Those in their 60s, in particular, may want to save this column. Most of these folks don’t even think about RMDs. In time, however, they will, and it will become blatantly obvious that these taxable distributions aren’t pocket change.
Article created by MarketWatch