6 Legal Ways to Avoid Taxes on RMDs

If you have money in certain retirement accounts such as a traditional 401(k) or traditional individual retirement account, you will be required to start taking required minimum distributions (RMDs) 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.

It’s important to avoid tax on RMDs if possible so you’re not throwing money away. Here are six possible options to reduce or avoid a tax bill on these mandatory distributions from retirement accounts.

When you have a tax-advantaged retirement plan such as a 401(k) or IRA, the IRS wants to ensure you eventually take money out of the account so it can collect taxes.

To ensure the government gets its piece of your earnings, required minimum distributions start at age 72 for the following types of accounts:

• Traditional IRAs
• SIMPLE IRAs
• SEP IRAs
• 403(b) plans
• 401(k) plans
• 457(b) plans
• Profit-sharing plans
• Other defined contribution plans

If you have a Roth IRA, on the other hand, no withdrawals are required by the government until after the account owner has died.

RMDs are based on your account balance and life expectancy. The IRS has provided both RMD worksheets and tables you can use to calculate the amount to withdraw from your account. The table you'll use depends on whether you are married or single, and whether you are basing your withdrawals on a single life expectancy or on the life expectancy of a younger spouse.

If you do not take your RMDs when required, you will have to pay a 50% penalty on the money you were required to withdraw from your account. But if you do take them, you'll be taxed at your ordinary rate on the money.

Taking these six steps could help you to avoid or reduce taxes on RMDs in many situations.

With traditional IRAs, you can typically deduct your contributions on your income taxes. With Roth IRAs, you contribute after-tax funds so you don’t have to worry about taxes later.

Because RMDs are not required from a Roth IRA, you may be able to avoid having to take these minimum distributions if you move your retirement money from a traditional IRA, 401(k), or another tax-advantaged account into a Roth IRA. You can do this with a Roth IRA conversion, which occurs when you roll your money over from your traditional account into a Roth.

However, when you roll over your money into a Roth, this is a taxable event. You will owe taxes on any pre-tax funds you are converting.

You'll pay taxes at your ordinary rate, and this could lead to a substantial tax bill. The advantage of a Roth rollover is that the taxes are done. You won’t need to take RMDs, and you won’t need to pay taxes on any distributions you take after making the conversion.

You should be aware, though, that to make tax-free withdrawals, you must have made your first contribution to a Roth account at least five years before you begin making withdrawals. You also must have completed the Roth conversion at least five years before you withdraw those funds. If you take a distribution within five years of the conversion, you could owe a 10% penalty and ordinary income tax.

If you decide to do a Roth conversion and you’re already older than 72, you’ll need to take your RMD first to meet your RMD requirement, as a Roth conversion doesn’t count as an RMD.

If you have a 401(k), 403(b), or other small business retirement plan, you do not have to take RMDs starting at age 72 if you are still working and don’t own more than 5% of the business. In these situations, you could wait to take RMDs until April 1 in the calendar year after you retire.

However, this works only for your current employer’s plan. If you have a traditional IRA or a 401(k) from a company you no longer work for, you will still need to take your RMDs at 72.

If you don't need the funds from RMDs starting at 72, you can use some of the money in your 401(k) or IRA to purchase a qualified longevity annuity contract, or QLAC. You are limited to contributing a maximum of $135,000 to a QLAC, and you cannot contribute more than 25% of any particular retirement account to fund your QLAC.

When you fund a QLAC, you can choose to start receiving income from it at a designated start date, which could be as late as 85. Any of the money you have invested in your QLAC will no longer count when RMDs are calculated. This means you don’t have to withdraw as much, which lowers your tax bill.

The QLAC will produce guaranteed income on a set schedule starting at your chosen age, and the later the age you select, the higher your payout will be.

Oddly, the age of your spouse can affect the amount of required minimum distributions you are mandated to take. The IRS allows you to use different life expectancy tables depending on your unique situation. The amount of your RMD is based on the balance of your accounts at the end of the previous year and a life expectancy factor based on the ages of you and your spouse.

If you are unmarried, have a spouse who is fewer than 10 years younger than you, or your spouse isn't the sole beneficiary of your IRA, you'll use the Uniform Lifetime Table. But if your spouse is more than 10 years younger and is the sole beneficiary of your IRA, you'll use the Joint Life and Last Survivor Expectancy Table.

The Joint Life and Last Survivor Expectancy Table allows you to withdraw a smaller amount of your account balance each year. And because you're taking out less money, you won't owe as much in taxes.

If you don't need the money to supplement your retirement income, you have the option to donate all or part of your required minimum distributions directly to a charitable organization by taking a qualified charitable distribution. The IRA will send the money directly from your account to the qualified charity of your choosing. You can then exclude the amount of the charitable contribution from your taxable income.

You must be at least 70 1/2 to begin making QCDs, and you can make a maximum of $100,000 in qualified charitable distributions annually. You also must make sure to take the QCD by the deadline for the year's required minimum distribution (for most, the deadline is Dec. 31).

You can wait until April 1 of the calendar year after you turn 72 to take your first RMD. Some retirees wait to take their RMD because they think they’ll be in a lower tax bracket that year.

If you wait and take your first distribution the year after you turn 72, you’ll have to take another RMD by Dec. 31 of that year. Taking two RMDs could mean a larger-than-expected tax bill for that year.

Depending on your situation, it might be better to take your first RMD the calendar year you turn 72. A tax or financial advisor can help you decide on the best timing for taking your RMDs.

Is it better to take an RMD monthly or annually?

There is no one single best approach to taking RMDs. You can take them in a lump sum at the beginning or end of the year, or you can take them periodically by withdrawing the money each month. It all depends on how you would prefer to receive your retirement funds.

Are RMDs taxes as ordinary income?

RMDs are taxed as ordinary income. That means you will pay taxes at your ordinary income tax rate. If you take a large distribution, this could potentially increase your taxable income and push you into a higher tax bracket.

How much of an RMD is taxable?

The entire RMD amount is taxable. These distributions are taken from pre-tax retirement accounts and are taxed at your ordinary income tax rate. By contrast, distributions taken from a Roth IRA are not taxed as long as you've followed withdrawal requirements, and Roth IRAs are not subject to RMDs.

What is the penalty for not taking an RMD?

If you do not take an RMD as required, you can face a tax penalty of 50% of the amount you should have withdrawn from your account but didn’t.

If you’re considering how to manage your money as a retiree, RMDs can complicate things. You may not want to take money out of your retirement accounts on a set schedule determined by the IRS. But you must make sure to comply with RMD rules to avoid penalties — and you must be ready to pay taxes on the distributed funds.

The best tax software can help you to understand your tax obligations and ensure you're paying the least amount of income tax possible.