Planning can help optimize annual RMDs depending on your goals and cash flow needs. Mandatory withdrawals from retirement accounts begin for most taxpayers at age 72. But retirees who don’t need the money often have questions. For example, what’s the best time of year to take required minimum distributions, how to reinvest it, or if you can avoid paying tax on RMDs.
Here are some of the most common RMD questions and planning opportunities for investors. And while there isn’t just one best way for everyone to take required minimum distributions, there’s probably one way that works best for you. At least this year.
What’s the best time of year to take your RMD? Lump sum or monthly?
All else equal, (though it rarely is), it’s often best to stay invested as long as possible to prolong tax-deferred growth. Of course, this assumes several key factors: the market is going up, you don’t need the money, and there aren’t any tax savings in considering alternate approaches (more on this later). Trying to market time your RMD on a daily basis is sure to be met with mixed results.
To illustrate: between 1980 and 2021, the S&P 500 closed a daily trading session with a positive price return only 54% of the time. But over a full year, the S&P 500 ended the year with a positive price return over 75% of the time.
Given that statistic, retirees without cash flow needs could benefit, on average over the long run, from staying invested and taking withdrawals closer to year end.
If you need the money from your retirement accounts to meet cash flow needs, there’s less room for optimization. Taking RMDs monthly, quarterly, or semi-annually is possible, though you’ll want to consider trading costs relative to the size of the distribution. Further, if you’re not working with a financial advisor, consider your appetite for frequent trading.
How to take RMDs and avoid any taxes (legally of course)
Retirees can donate all, or a portion of, their required minimum distribution directly to charity to legally avoid paying tax on the gifted amount. It’s called a qualified charitable distribution (QCD). You can make QCDs starting at age 70 1/2. The maximum gift is the lesser of your RMD or $100,000/year per taxpayer. Usually, to benefit from charitable giving, taxpayers need to itemize their tax deductions. But with a qualified charitable distribution, the money is simply excluded from your taxable income for the year, similar to a 401(k) contribution.
Like any tax planning strategy involving charitable giving, you must be charitably inclined for it to make sense.
Can you reinvest your required minimum distribution?
Yes, you can reinvest your RMD. There are a couple ways to do it. The easiest way is often selling investments in a retirement account and transferring cash to a taxable brokerage account. Investors typically wish to do some tax withholding at this stage and move the net amount, but if you have enough cash set aside already it isn’t necessary.
Another method which tends to works best for large required minimum distributions is transfer shares in-kind from your retirement account to a brokerage account. Particularly in a down market, this approach can be beneficial for investors who don’t need the money right now.
Some shares can be sold for tax withholding if necessary. This method may require some paperwork depending on the financial institution. Also, as markets move daily, the actual value of the investments transferred may be higher or lower than your RMD. The latter requiring an additional transfer or distribution.
Although you cannot reinvest your RMD directly in an IRA or a Roth IRA, if you have earned income for the year, you may still be able to contribute to one of these accounts.
Should you delay distributions from retirement accounts as long as possible?
To simplify, RMD age is often referred to as beginning the year you turn 72. But technically, taxpayers have until April 1st of the year after they turn 72 to take their first distribution. If you defer, you’ll need to take two required minimum distributions the year you turn 73.
For example, if you turn 72 in 2022, your 2022 RMD is calculated using your retirement account balance on 12/31/2021, divided by the Life Expectancy Factor from the IRS Uniform Lifetime Table. Your 2023 required distribution is based on your account balance from 12/31/2022. If you don’t take your 2022 RMD this year, you have to take both in 2023.
In most cases, delaying distributions this way isn’t beneficial. For starters, the surge in taxable income at age 73 can put you in a much higher tax bracket and also increase Medicare Part B premiums. Further, it could be a wasted opportunity if you were in lower tax brackets before turning 72.
For these reasons, it sometimes makes sense to consider starting RMDs at 72 or even beforehand. For example, taking advantage of low tax brackets by doing a series of Roth conversions before RMDs begin or simply paying tax at low rates to avoid the dreaded tax cliff.
However, there are instances where deferring distributions as long as possible is advantageous. Consider a business owner selling a business at retirement or individual experiencing another type of windfall. If you’re in the highest marginal tax bracket one year but not the next, there’s a potential planning opportunity.
Retirement income planning
There are many factors that go into retirement income planning. Unfortunately, most of the best planning opportunities occur before RMD age. The best approach can also change every year. For example, even when markets are down, it won’t change your required withdrawals for the current year. However, it’s likely your mandatory distribution the next year will be lower. Perhaps this meets your cash flow needs, but perhaps not. In either case, it’s a new year to try and optimize your required minimum distributions.