Here’s my simple explanation of required minimum distributions (RMDs): At age 72, Uncle Sam knocks on your door and asks you to pay taxes on your tax-deferred investments. You’ve gone perhaps years without paying taxes on these accounts, and he’s $30 trillion in debt. In more technical terms, an RMD is when you take out a specific percentage (based on the IRS life expectancy table) from your tax-deferred investments (401(k)s, IRAs, etc.) and pay taxes on it.
The older you get, the more that percentage increases. Most retirees not only see an increase in that percentage, but they also see their investments grow. This combination may cause you to take out significantly more in the future, which can cause issues when it comes to paying taxes. It could push you into a higher tax bracket, cause Social Security to be more taxable, push you into a higher Medicare premium bracket and cause capital gains to be taxable or more taxable.
Now, what if you don’t want to take your RMD? Can you just pass on it? You do not want to do this, as the penalty is a 50% tax. I know not everyone wants to take out their RMD, but this is something you don’t want to miss. Luckily, there are a few ways to make RMDs a little less troublesome.
Strategy 1: Roth Conversions
You could deal with this now by reducing your RMDs in the future. This could involve taking money from your tax-deferred investments before age 72 or utilizing a Roth conversion strategy. A Roth conversion is when you take money from a tax-deferred investment and move it to a Roth IRA.
You have to pay the tax now on this strategy, but it can make a lot of sense while the tax rates are low and before that investment has the opportunity to grow more. When your money is in a Roth IRA, you are not required to take out RMDs, which allows your money to grow tax-free. Also, all the money you take from this account will be tax-free and not count as income, as long as you are 59½ or older and have had a Roth open for at least five years.
Please note that if you’re 72 or older and taking RMDs, you can still do a Roth conversion, but you have to take your RMD out first before you do a conversion. For example, if you are required to take out $10,000 from your IRA, but you want to do a $5,000 Roth conversion, you would take out $10,000 first (which cannot be converted). You would then convert $5,000 on top of that, which means your total taxable withdrawal amount would be $15,000.