When you’re eager to lower your tax bill, saving for retirement through a traditional IRA or 401(k), as opposed to a Roth, may seem like a good idea. But traditional retirement plans have a huge drawback. Not only are withdrawals subject to taxes, but you may end up having to take the withdrawal even if you don’t want to.
These mandatory withdrawals are called required minimum distributions (RMDs). They start at age 73 or 75, depending on your birth year.
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RMDs can cause you a host of retirement problems. Not only can they push you into a higher tax bracket, they can also push up the cost of your Medicare premiums by making you pay a surcharge known as IMRAA, or income-related monthly adjustment amount.
Good news? There is one step you can take to reduce your RMDs in retirement. But you need to plan ahead to make this happen.
Roth conversions are a good option to get rid of or reduce RMDs. But many people wait until the last minute to make a Roth conversion and end up taking a large lump sum out of a traditional retirement account. This often results in a very large tax bill.
Also, depending on your age, making a large Roth conversion within a year may put you at risk for Medicare IRMAA. Therefore, a better option may be to switch over time.
Another option that many people overlook? No conversion is required, just withdraw the funds from your IRA or 401(k) before the RMD begins.
Let’s say you have to start taking RMDs at age 73, but you retire at age 65. During this eight-year interval, your income is likely to be quite low and therefore in a fairly low tax bracket.
If you withdraw funds from an IRA or 401(k) during this period, you will have fewer RMDs to pay later. You can then reinvest the withdrawn funds so nothing goes to waste.
If you make these withdrawals in a year when your income is fairly low, not only will your tax bracket not rise too much, but you may not risk pushing your income into the IRMAA range. All in all, this is a strategy that can save you a lot of financial pain.
One reason seniors have trouble with RMDs is that they wake up at the last minute and realize they are a year or two away from a potentially large mandatory withdrawal. A better choice? Plan early.
