People often think they don’t have any choice about taking the IRS-mandated required minimum distributions from their retirement accounts – but they do. While you can’t skip making the withdrawal they can choose how to time it in a way that works best for their individual financial situation.
Required minimum distributions – RMDs, for short – kick in at age 73 and apply to all of your tax-deferred retirement accounts, such as regular Individual Retirement Accounts and 401(k) accounts. Neither the original principal or the gains in those accounts ever have been taxed, and the IRS is willing to wait just so long before the agency insists on taking its bite of the money.
You, however, can choose when and how to take the distribution, whether that’s at the beginning of the year, the end of the year or in a stream of monthly, quarterly or semi-annual payments. Each has its pluses and minuses, but none will change the amount of your RMD – that’s based on the value of your retirement accounts at the end of the previous year and your age.
A financial advisor can help you structure your RMDs to your best advantage.
The “just get it over with” approach works for people who need the cash flow during the year and helps avoid needing to borrow money or put expenses on credit cards and paying the resulting interest. You also can put the cash into another investment right away, as long as it’s not a tax-advantaged retirement account.
On one hand, this approach guarantees that you won’t forget to take your RMD but it also means all that money won’t be generating any additional gains in your retirement account, although you can deposit some or all of the cash to earn interest. Another potential downside is that if tax laws change on RMDs – such as in March 2020 when Congress eliminated RMDs for that year because of the pandemic – you’ll have already taken your distribution and miss out on that break.
This approach smooths your cash flow all year if you’re using the money to pay your living expenses. It also keeps some of your RMD money in your investments for part of most of the year to generate new gains. With a quarterly distribution schedule, you can time the distributions and use the cash to cover your quarterly estimated tax payments on other income, as well as the RMD itself.
If you don’t need cash to cover expenses earlier in the year, leaving your RMDs until the end of the year maximizes the potential investment returns on the RMD money, while also leaving the option to take advantage of any changes to RMD rules that take place during the year. You also can withdraw a lump sum large enough to cover all your income tax for the year.
Whatever schedule you use for RMDs won’t change the amount of taxes due on the distribution. However, your RMD schedule can affect your other taxes. If you make quarterly estimated tax payments based on your RMD amount and all your other taxable income, you’ll lose the use of your tax money for the rest of the year.
But there is a very neat trick that allows you to simplify your tax payments using RMDs and hold on to your tax money all year long.
Here’s how it works: To avoid a penalty for underpaying your estimated federal taxes, you need to pay either 90% of your tax bill for the year or 100% of your tax bill from the previous year through withholding or estimated tax payments throughout the year. However, any taxes withheld from retirement account distributions are considered “ratable” – paid evenly throughout the year – no matter when the payment is made.
This means you can take your RMD late in the year when you can make the most accurate estimate of your tax bill and have that amount withheld from your RMD to cover your taxes for your RMDs and other income. This eliminates the hassle of making estimated payments and the risk of overpaying your estimated taxes and giving the IRS an interest-free loan all year instead of using the money yourself.
When and how often you take your RMDs during the year can help you manage your cash flow and maximize the potential investment gain of your RMD money before it’s withdrawn.
Balancing taxes and retirement income – and figuring out how to minimize taxes in retirement – is a crucial issue. A knowledgeable financial advisor help you decide how to structure and coordinate these payments over the span of your retirement.
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Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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