Required minimum distributions (RMDs) are typically not something that investors particularly love. That’s because the reality is RMDs should be renamed “required minimum taxable distributions.”
As a refresher, RMDs refer to the minimum amount you have to withdraw from your account each year after you reach age 70½ and apply to your traditional, SEP and SIMPLE IRAs, and qualified retirement plan accounts.
More than likely, your tax-deferred accounts were the result of 401(k) contributions that were pretax and deductible IRA contributions. And therein lies good ol’ Uncle Sam’s desire to reach into our pockets. The IRS wants their cut – what they don’t want is for your tax-sheltered accounts to stay that way forever.
So, once you take your RMD, the government treats it as ordinary income, therefore making it taxable. This is what makes RMDs so unlovable.
What’s fascinating to me is that once forced to take RMDs, many folks may feel that they have to spend the money. But you don’t have to by any stretch. If you already have enough retirement income to meet your needs, there are a handful of things you can do with the RMDs instead.
Many people don’t want to tap these accounts in the first place. According to Fidelity, over half of their customers wait until RMDs kick in before they begin drawing down from their accounts. This fact shows that a lot of people want to keep their money invested for as long as they can.
On that note, here are three strategies to consider for making the most of your RMDs:
1. Reinvest the RMD
There are options to keep your money invested once you’ve withdrawn it. Things like money-market accounts or other interest-bearing vehicles are options you could consider. If you choose the money market route, you’ll have the bonus of readily available cash should you need it for an unforeseen cost.
You could also choose to put the money into a brokerage account to invest in the same type of vehicle you were in with your retirement account. If you were invested in an index-tracking fund, set yourself up to stay the course.
And, if you choose the cash route, be sure that you’re getting a good interest rate. You want to make sure your money is working for you.
2. Consider a Roth IRA Conversion
Retirees can effectively reduce their RMD amounts by converting a portion of a traditional IRA to a Roth. This plan will lower your RMDs in the future. It could especially make sense during the early years of retirement when you’re living comfortably on your investments, Social Security benefits, and other income streams.
That’s because, during this time, your taxable income is probably relatively low. Retirees can choose to stagger converting their traditional IRA funds into a Roth IRA over time – say spread out over several years – to avoid getting bumped into a higher tax bracket during any one year.
While you will inevitably pay taxes on withdrawals from your traditional IRA, Roth IRAs offer a slew of advantages to help justify this move. For instance, Roth IRAs don’t have RMDs, and you don’t pay taxes on withdrawals. By making the conversion, you get the benefit of still being invested in a tax-friendly way.
There are a few pitfalls to be sure to avoid. For instance, if you’re younger than 59½, you may be subject to penalties if you withdraw the money you rolled over into your Roth. So, making this conversion isn’t the best strategy if you think you may need the money soon.
3. The Gift of Giving
Consider making a qualified charitable donation (QCD). These QCDs go straight from IRAs to charities; since you never get the money, you aren’t exposed to tax on it. This tool can be powerful for retirees who are worried about increasing their taxable income to the point of higher taxes on their Social Security benefits and surcharges to their Medicare premiums.
When you’re faced with the dreaded RMDs, consider these tips for how to manage your cash, as opposed to just letting it go out the door. After all, the IRS mandates that you take the money out, but they don’t require that you spend it.