Strategy #: Roll The Money In Your Ira Into A Roth
While there are numerous calculations that are required to determine if the following strategy makes financial sense, because Roth IRAs never require RMDs, a few of the scenarios whereby rolling the money from your IRA into a Roth IRA could be advantageous, include:
- Youre going to be in a higher tax bracket when you use the money.
- You know you want to reduce the amount of your future RMDs.
- You want to pass money along to your family that is tax free.
Remember, while youll have to pay income tax on the money you transfer from your traditional IRA , you get to reinvest that money in a vehicle where it will grow tax free and not ever be subjected to RMDs.
When it comes to retirement, and to both legally and ethically keep as much of your hard-earned cash as possible, there are obviously a lot of things to consider.
I end a lot of articles with some version of what Im about to say, but thats because I strongly believe that what we do at Allworth Financial helps people achieve their financial goals and positions them to better enjoy a lifestyle of their choosing.
Simply, the strategies above are complex processes, and just potential suggestions for your overall financial plan, all of which are of course intended to help you retire better.
Please speak with your fiduciary advisor before using these, or any other strategies, related to investing, taxes, finance, or retirement.
Strategy #: Give The Rmd To Charity
For exceptionally good savers, there is a terrific way to meet your RMD requirement and pay absolutely no taxes on it.
Once you hit the age where you must take RMDs, turning that withdrawal into a qualified charitable distribution by directly transferring the funds to a charitable entity could be a viable strategy for some people.
While I encourage you to speak with your advisor before following this route, here are some basic considerations regarding the process of transferring your RMD directly to a non-profit.
First, the custodian of your IRA must transfer the funds directly. Next, while you cant double dip and later claim the charitable transfer on your taxes as a deduction , the beauty of this is that it potentially keeps you from being shoved into a higher tax bracket.
A third, and not insignificant, consideration to all of this is that giving money to a well-run charity is a heck of a nice thing to do.
Calculating Required Minimum Distributions For Designated Beneficiaries
Generally, for individuals or employees with accounts who die prior to January 1, 2020, designated beneficiaries of retirement accounts and IRAs calculate RMDs using the Single Life Table ). The table provides a life expectancy factor based on the beneficiarys age. The account balance is divided by this life expectancy factor to determine the first RMD. The life expectancy is reduced by one for each subsequent year.
If the distribution is from a qualified retirement plan, the plan document will establish the RMD rules, and the plan administrator should provide the beneficiary with his or her options. The options for the RMD pay-out period may be as short as 5 years, or as long as the life expectancy of the beneficiary. Therefore, if the distribution is from a qualified plan, the beneficiary should contact the plan administrator. For IRA distributions, see Publication 590-B, Distribution from Individual Retirement Arrangements , or this chart of required minimum distributions to help calculate the required minimum distributions.
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How To Avoid Paying Income Tax With Individual Tax Credits
You can think of tax credits in terms of two broad categoriesindividual and business credits. The names make it clear which credits are aimed at what type of taxpayer.
Common individual tax credits include:
7. Child Tax Credit
If you have children, each child may qualify you for up to a $2,000 credit on your tax bill. Dependents who arent your children still count but will qualify you for up to $500 per dependent.
8. How to Avoid Income Taxes With an Earned Income Tax Credit
If you fall into specific earning categories, you could qualify for a significant tax credit. In addition to an income threshold, youll need to meet several other requirements, which include:
- Less than $3,650 in investment income
- Must file jointly if married
- Youre ineligible if you file Form 2555, or 2555-EZ
- At least $1 of income in the tax year
The earned income tax credit will range between $543$6,728 based on filing status and the number of dependents for tax year 2021.
9. How to Avoid Paying Taxes at the End of the Year With a Residential Energy Credit
Residential energy credits are relatively underused but can mean significant savings under the right circumstances.
In short, its a federal tax credit of a portion of the installation costs of solar energy systems. The tax credit was 26% in 2020 and falls to 22% in 2021. As it stands, this credit expired in 2021, so now is the time to install those solar panels if you havent already.
11. How to Not Pay Taxes Using a Lifetime Learning Credit
Attach A Letter Of Explanation To Each Form 5329 Submitted For Penalty Relief
Form 5329 provides the IRS with the hard data, but it doesnt, by itself, provide a taxpayer with a way to explain to the reasonableness of both their error and their corrective measure to the IRS. That part must be accomplished by attaching a note to Form 5329 to make the taxpayers case for penalty relief.
In general, the note should be short, and to the point. It should include the years in which RMDs were missed, the amount of the RMD shortfall in each year, the corrective actions taken, and the reason the errors occurred in the first place. See our Sample Letter Of Explanation For Missed-RMD Penalty Relief Alongside Form 5329.
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Christopher D Nelson Jd
Vice President of Development and Donor Engagement
Christopher D. Nelson is the Vice President of Development and Donor Engagement at the Catholic Community Foundation, where he serves individuals, parishes, and Catholic nonprofits in meeting their philanthropic and stewardship goals.
Prior to his work with CCF, Chris was a partner at a law firm in Southern Minnesota where he represented a wide variety of nonprofits, including Catholic dioceses and parishes. He also provided legal counsel to individuals and financial institutions regarding asset protection, corporate governance, charitable giving, and tax and general business planning. Chris earned his doctor of jurisprudence from the University of St. Thomas where he served as Editor in Chief of the UST Law Journal.
Chris serves on the board of directors for a community bank and on the Minnesota Council on Foundations tax committee. He previously served as chair of the United Way of Olmsted Countys board of directors and sat on the boards of the Rochester Community and Technical College Foundation and First Alliance Credit Union.
Use Your Rmd To Pay Your Taxes
You can also use your RMD to simplify tax payments. With the RMD solution, you can ask your IRA custodian to withhold enough money from your RMD to pay your entire tax bill on all your income sources for the year. That saves you the hassle of making quarterly estimated tax payments and can help you avoid underpayment penalties.
Because withholding is considered to be evenly paid throughout the year, this strategy works even if you wait to take your RMD in December. By waiting until later in the year to take the RMD, youll have a better estimate of your actual tax bill and can fine-tune how much to withhold to cover that bill.
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Date That You Turn 70
You reach age 70½ on the date that is 6 calendar months after your 70th birthday.
Example: You are retired and your 70th birthday was June 30, 2018. You reached age 70½ on December 30, 2018. You must take your first RMD by April 1, 2019. You will take subsequent RMDs on December 31st annually thereafter, as will be discussed below.
Example: You are retired and your 70th birthday was July 1, 2019. You reach age 70½ after December 31, 2019, so you are not required to take a minimum distribution until you reach 72. You reached age 72 on July 1, 2021. You must take your first RMD by April 1, 2022, with subsequent RMDs on December 31st annually thereafter.
Penalties For Missing Rmd Deadlines
What happens if you miss the deadline? You could get hit with one of Uncle Sams harshest penalties50% of the shortfall. If you were supposed to take out $15,000 but only took $11,000, for example, youd owe a $2,000 penalty plus income tax on the shortfall.
But this harshest of penalties may be forgivenif you ask for reliefand the IRS is known to be relatively lenient in these situations. You can request relief by filing Form 5329, with a letter of explanation including the action you took to fix the mistake.
One way to avoid forgetting: Ask your IRA custodian to automatically withdraw RMDs.
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Can I Convert My Rmd To A Roth
Yes, you can do Roth conversions in a year where you also take required minimum distributions . There is no age limit for Roth conversions. The only thing that changes is that the RMD must be made first, then any remaining distributions can be Roth conversions if you wish. The only requirement is the $30,000 RMD.
Rmds For Inherited Accounts
If you inherit a 401 from someone else, you are also required to take RMDs. However, the rules for when and how you must take them out differ depending on whether you’re the spouse of the deceased or a non-spouse beneficiary, among other factors.
- If you inherit a 401 from a spouse, you’ll have a choice of rolling the money over to your own 401 or IRA and taking RMDs as if the account had been your own all along or transferring assets into an inherited IRA and taking distributions based on your life expectancy using the IRS Single Life Expectancy table. Distributions generally must start by the year your spouse would have turned 72 or by December 31 of the year after your spouse’s death if your spouse was 72 or older.
- If you inherit from a non-spouse who died after Jan. 1, 2021, you’ll generally need to roll the money into an inherited IRA and withdraw all assets within 10 years. However, different rules apply for “designated beneficiaries,” including disabled individuals.
If you have a 401, be sure to read up on the rules of required minimum distributions so you’re not caught off-guard down the line. The last thing you want is to forgo some of your hard-earned savings because you failed to take your RMDs in time.
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Minimize Taxes On Required Minimum Distributions Through Dynamic Withdrawals In Retirement
When you retire, depending on how youve saved for retirement, you should have a few options to meet your income needs. Even if required minimum distributions havent started yet, it doesnt mean you should wait to tap retirement accounts.
Depending on your overall pool of investable assets, pension, Social Security income, and other revenue sources, you should consider customizing a tax-efficient withdrawal strategy. Retirement planning projections are a great start, but tax brackets change and so too will your account size which makes income in retirement an ongoing effort to minimize tax.
For the best outcome, youll want to consider working with a fee-only financial advisor to support your goals.
Take The Money From The Right Accounts
The rules about which account to tap for the withdrawal are different for IRAs and 401s. If you have several traditional IRAs, you add up the total RMDs required from all of them, and then you can withdraw the money from one or more of the accounts.
But if you have several 401s, you have to calculate the RMD for each of them and withdraw the money separately from each account. Also, you cant take IRA required distributions from a 401 or vice versa.
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How Is My Rmd Calculated
Your RMD is determined by dividing your prior year-end retirement account balance by your life expectancy factor .
Many companies, including Vanguard, will calculate your RMD for you. You can also use our tool to estimate your RMD.
If you have multiple accounts
You’ll have to calculate your RMD for each IRA and employer-sponsored plan separately.
When you take RMDs from your IRAs, you can withdraw them from any account you choose.
For example, if you have 2 IRAs and 1 has an RMD of $1,000 while the other has an RMD of $2,000, you can take the entire $3,000 from 1 of your IRAs or you can take a certain amount from eachit’s up to you.
Employer plans work differently. You have to take each RMD amount from the specific account it was calculated for.
What Is A Backdoor Roth Conversion
A backdoor Roth IRA lets you convert a traditional IRA to a Roth, even if your income is too high for a Roth IRA. Basically, a backdoor Roth IRA boils down to some fancy administrative work: You put money in a traditional IRA, convert your contributed funds into a Roth IRA, pay some taxes and youre done.
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Is It Better To Take Rmd Monthly Or Annually
As an age-72-or-older IRA owner, you have options regarding when to take your annual required minimum distribution . You can take it early in the year, take it in monthly or other periodic instalments, or wait until the last minute. Which is best? Surprisethere is no one best time to take the RMD.
How To Calculate Your Required Minimum Distribution
To determine your required minimum distribution , you start with your account balance as of December 31 preceding the calendar year you need to withdraw your RMD amount. You use that account balance and divide it by the distribution period from the IRS Uniform Lifetime Table.
Usually, your retirement plan broker or plan sponsor will calculate the RMD for you every year. If you havent received your RMD, do not delay and find out your RMD. You will need your RMD to plan accordingly, so you can avoid the 50% penalty. Do not wait until it is too late!
The IRS has a worksheet that includes the Uniform Lifetime Table and walks you through how to calculate your RMD, which can be found here, unless your spouse is the sole beneficiary and more than ten years younger than you. If both your spouse is your sole beneficiary and more than ten years younger than you, you can use the worksheet here to calculate your RMD.
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How Rmds Are Calculated
Now, before I get into some strategies that could help you lower your retirement tax burden, a quick word about how RMDs are calculated.
Each year, the government adds together all the money in your tax-deferred retirement accounts and divides it by several different calculations, including your life expectancy. The older you are, from a percentage standpoint, the larger your RMDs will likely be. And the larger the RMD , the higher your tax burden is likely to be. Unless you plan.
Okay, so perhaps youre thinking that youll just have to pay a few more dollars in taxes on a large RMD withdrawal, right?
Wrong. Remember, the tax on your RMDs doesnt occur in a vacuum.
Simply, its not just that the RMD is taxed its that the money from that withdrawal is applied to all your taxable retirement income. So, if your retirement income jumps by, say, $70,000 because of the size of your RMD, and your overall tax burden gets bumped up by, say, 10 percent? Or, maybe more?
You could find yourself forced to pay tens of thousands of extra dollars in taxes than was absolutely necessary.
One answer could be to lower the size of your RMDs.
But how?
What follows are 3 RMD strategies that could lower your future tax burden and save you money.
How Do I Pay Taxes On My Required Minimum Distribution So I Dont Get In Trouble With The Irs
It depends. Tax law requires the payment of income taxes throughout the year as you earn income. This obligation can be met through quarterly estimated tax payments, tax withholding, or both. It is a good idea to set aside a portion of the money withdrawn from a tax-deferred retirement plan for the required minimum distribution and make quarterly estimated tax payments to the IRS unless your plan custodian provides income tax withholding services. The IRS provides payment vouchers to people who make estimated tax payments, and they are due April 15, June 15, September 15, and January 15 of the following year for the first, second, third, and fourth quarters, respectively.
The only other option, if your plan sponsor does not withhold for taxes, would be to overwithhold household income taxes somewhere else to cover the expected tax liability. It is very important to determine your expected tax liability and withhold sufficient taxes so you are not assessed an underpayment penalty. See IRS Form 505 and Publication 505 for worksheets.
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Legal Ways To Avoid Taxes On Rmds
If you have money in certain retirement accounts such as a traditional 401 or traditional individual retirement account, you will be required to start taking required minimum distributions after your 72nd birthday. That means you must start withdrawing a minimum amount of money from your tax-advantaged retirement account on a schedule determined by the IRS.
When you withdraw the money from these accounts, you will have to pay taxes on those distributions at your ordinary income tax rate. This can sometimes lead to a big tax bill. And because the distributions are taxable income, they could even push you into a higher tax bracket or make your Social Security benefits partially taxable.
Its important to avoid tax on RMDs if possible so youre not throwing money away. Here are six possible options to reduce or avoid a tax bill on these mandatory distributions from retirement accounts.
