The Hidden Tax Trap Waiting for Retirees — and How to Avoid It
Retirement planning involves saving up a large enough nest egg to cover your expenses, but it also entails being prudent about taxes.
That’s why it’s important to understand how required minimum distributions (RMDs) — mandatory withdrawals from your tax-deferred retirement accounts like 401(k)s and individual retirement accounts (IRAs) — will factor into your tax bill. Here’s what you need to know, and how to potentially lower your tax burden.
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What to know about taxes on RMDs
RMDs take effect when you turn 73 (or 75 for those born in 1960 or later). The IRS uses a life expectancy factor to calculate your RMD, and as you get older, your RMD goes up.
Withdrawals from traditional retirement plans are generally treated as ordinary income, which means they can potentially push you into a higher tax bracket. It’s important to consider all your income when preparing your taxes, including RMDs, dividends and payments from Social Security and pensions.
Your income can also impact if you have to pay taxes on your Social Security payments, and how much. The amount of money you’ll have to pay in federal taxes on Social Security depends on your "combined income," which includes your adjusted gross income, tax-exempt interest income and half of your Social Security benefits.
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How to lower your RMD tax burden
While RMDs are subject to taxes, there are strategies you can use to lower your tax burden. Here are four to consider.
1. Make a qualified charitable distribution
People who are age 70½ or older can make qualified charitable distributions (QCDs) from their taxable IRAs instead of taking RMDs. These donations do not count toward taxable income, meaning you may be able to lower your income enough to put you in a lower tax bracket.
2. Do a Roth conversion
Roth retirement plans don’t qualify for RMDs and allow you to grow your nest egg tax-free. One option is to use a Roth conversion to move traditional retirement funds into Roth accounts — though you’ll have to pay taxes on the converted funds in the year that you convert the money. You should carefully consider your tax situation and, if possible, discuss the move with a financial advisor before moving forward.
3. Max out your health savings account (HSA)
Health savings accounts (HSAs) may have lower contribution limits than other retirement accounts, but they come with a triple-tax-advantage: Contributions can lower your taxable income, grow tax-free in the account and withdrawals are tax-free as long as they’re for qualified medical expenses. They don’t have RMDs and can help lower your overall tax burden later in life.
4. Don’t wait for RMDs to start withdrawing
You can start withdrawing from tax-deferred retirement accounts at age 59½ without penalty, and doing so means lowering the balance of your accounts and future RMDs. Just remember, withdrawing your money early also means it will miss out on potential growth in the years to come.