What You Need to Know
- There are a number of strategies that can reduce or defer your client’s RMDs.
- These strategies should be evaluated in the context of your client’s overall financial planning situation.
- Their tax situation and whether or not they need money from the RMDs are key factors to consider.
As we approach the end of 2021, it’s important to be sure that all clients have taken their full required minimum distributions (RMDs) for the year. As you are certainly aware, there is a 50% penalty on any RMD amount not taken by the deadline.
Beyond just managing RMDs, there are a number of planning issues surrounding RMDs not only for clients who must take them, but also for younger clients as they approach age 72.
Much of this planning centers on:
- Your client’s current and anticipated future income and tax brackets.
- Whether your client needs the money from the RMDs.
For many clients, there are steps that can be taken this year and in future years to reduce their RMD obligations from traditional IRAs and other retirement accounts, if this makes sense from an overall planning perspective.
Qualified Charitable Distributions (QCDs)
Qualified charitable distributions or QCDs allow those who are at least age 70½ to take up to $100,000 from their traditional IRA and direct it to qualified charitable organizations.
The benefit is that QCDs are not taxed. As far as RMD planning goes:
- QCDs taken prior to age 72 will reduce the amount in the traditional IRA that is subject to future RMDs.
- QCDs taken in excess of a client’s RMD amount on or after age 72 will serve to reduce the amount of future RMDs.
- Using QCDs for some or all of a client’s RMD will reduce the amount of the RMD that is taxable, while accomplishing the client’s charitable giving goals.
QCDs are an excellent tool for those who are eligible and who are charitably inclined. For clients in this situation who can’t itemize deductions, QCDs can be a tax-efficient method of making charitable donations while at a minimum reducing the tax bite of their RMDs.
Roth IRAs and Roth conversions have been in the news a lot lately. A Roth IRA conversion can be a solid overall planning tool, including as a vehicle to manage and reduce future RMDs.
Money converted to a Roth IRA, along with future earnings on that money, is removed from the pool of funds that are subject to RMDs in future years. If a client is already taking their RMDs, all RMDs must still be taken in the current year; doing a Roth conversion does not reduce any part of their RMD obligation in the year of the conversion.
The decision as to whether or not a Roth conversion is right for your client should be done in the context of their overall financial planning objectives. Considerations include:
- Current-year income and taxes. Years in which your client’s income is lower than normal can be good years to consider a Roth conversion. This might include the period after the client has retired but has not yet commenced taking Social Security benefits. Clients in this “gap” period often find themselves in a lower tax bracket than in other years.
- Are there potential non-spousal heirs to their IRA? If so, a Roth conversion can save these heirs on potential taxes after inheriting the IRA. The analysis should look at the overall family tax situation to see if it makes sense for your client to essentially prepay taxes for the next generation.
- Does your client need the money from the RMDs on the traditional IRA? If not, then paying the taxes now in exchange for the ability to allow the converted Roth funds to continue to grow tax-free could be a good trade-off.
Contributing to a Roth IRA or Roth 401(k) can be a means for clients to limit future RMDs. Contributions to a Roth 401(k) can be especially useful here, as there are no income limitations on their ability to contribute and the contribution limits are higher than for a Roth IRA.
Money held in a Roth IRA is not subject to RMDs. Money in a Roth 401(k) is subject to RMDs, though they are not taxed. This can be avoided by rolling the Roth 401(k) account balance over to a Roth IRA when leaving that employer.
Money in a Roth IRA is not only exempt from RMDs for the account holder, but also for their spouse if they inherit the Roth IRA. Additionally, Roth IRA money inherited by non-spousal beneficiaries will not be taxed if certain conditions are met.