Strategies for Managing Retirement Distributions

In most aspects of life, we sometimes hesitate to face challenges upfront, preferring to defer them to a later time. This procrastination is especially common when it comes to paying taxes on retirement distributions, affecting not just 401(k)s and IRAs but also the beneficiaries of these accounts.

With the passage of SECURE 2.0, Congress raised the RMD (Required Minimum Distribution) age to 73, up from the previous thresholds of 72 and 70½. While many welcomed this change as an opportunity to delay RMDs, this perspective might not be the most beneficial. Delaying RMDs can actually exacerbate the tax burden over time.

One potential approach is to take voluntary distributions before RMDs become mandatory. By doing so, you can pay some of the future taxes now at potentially lower rates and convert those funds into Roth IRAs. These Roth IRAs will then grow income tax-free for your lifetime.

Utilize the extra years before RMDs start to strategically move funds out of IRAs while tax rates are lower and more manageable. Once RMDs begin, controlling tax rates becomes increasingly difficult.

At age 73, when RMDs are required, the opportunity to convert these funds to Roth IRAs is lost. The first dollars withdrawn are allocated to RMDs and cannot be converted. Only after satisfying the annual RMD can any remaining balance be converted, often at a higher tax cost due to the taxes already paid on the RMD.

In addition to voluntary distributions and Roth conversions, another effective tax-saving strategy is the use of QCDs (Qualified Charitable Distributions) after age 70½. For those who already donate to charity, transferring IRA funds directly to charitable organizations can reduce IRA balances and future RMDs at zero tax cost. Once RMDs start, QCDs can help offset taxable RMD income.

Delaying RMDs from Employer Plans

Many 401(k) plans allow employees to delay RMDs beyond age 73 until they retire, under the “still working” exception. This exception applies only to the employer’s plan where the employee is still working and does not own more than 5% of the company. It does not apply to IRAs or other company plans, which require RMDs even if the owner is still working.

The same principle of avoiding long-term tax costs by not delaying RMDs applies here. However, this strategy involves a different approach: use the still-working exception to delay 401(k) RMDs while taking distributions from IRAs. Excess IRA distributions can be converted to Roth IRAs, utilizing lower tax brackets that might otherwise go unused.

If there are no IRA funds to withdraw and low tax brackets remain unutilized, it may be beneficial to take early withdrawals from the employer plan rather than delaying using the still-working exception.

IRA Beneficiaries and the 10-Year Rule

Beneficiaries of IRAs subject to the 10-year rule should also consider taking voluntary distributions over the 10-year term. This approach helps to smooth out the tax burden by taking advantage of lower tax brackets each year, rather than facing a massive tax hit in the 10th year when the remaining balance must be withdrawn.

Spreading distributions over the 10 years can make a significant difference in the overall tax bill. IRS Notice 2024-35 waived 2024 RMDs for beneficiaries who were initially subject to annual RMDs for the first nine years of the 10-year term. While this might seem like a positive development, it could lead to a larger tax bill due to the shortened distribution window.

Retirees should work with their advisor and their CPA to project clients’ and beneficiaries’ future income and tax rates to identify those who might benefit from taking early distributions. This proactive approach allows for better long-term tax planning and control over tax rates.

Delaying RMDs might sound appealing, but the tax bill will only grow larger. Paying taxes on retirement distributions now can lead to substantial tax-free gains in the future. If tax rates increase, tax-free funds will become even more valuable. By taking more distributions now, you can minimize the overall tax burden.