This 70-Year-Old Nearly Missed a Key Retirement Tax Deadline. Here's What He Wished He'd Known Sooner

This spring, soon after he turned 70, Drew Schofield began getting warning notices from financial institutions. It’s time, they told him, to start withdrawing money from the various IRAs and other retirement accounts he had accumulated over the decades.

Schofield, a resident of Providence, R.I., and an account executive managing sales relationships for office products company W.B. Mason, was taken aback. His age notwithstanding, he wasn’t thinking of retiring. He enjoys his job, and still has college-age children.

“I had never worked with a financial advisor, so I didn’t really understand that there would be a specific age that would come along, regardless of whether or not I was working, and bang, I would have to withdraw this money, whether or not I needed it,” he says. All things being equal, he says, he’d prefer to keep it where it is for a few more years, accumulating gains free of tax, until he actually does retire.

But the IRS isn’t willing to wait beyond the year you turn 70 ½ to collect its share of your retirement savings. After all, when you contributed to your retirement plans, you most likely used pretax dollars. That means that you deferred paying income tax on your contributions and any earnings. Current rules say that you can’t defer withdrawals beyond the year that you turn 70 ½. Starting then, the IRS requires you to take at least a certain amount from your traditional IRA or 401(k) each year and pay ordinary income tax on it. If you neglect to take these required minimum distributions, you will have to pay half of what you should have withdrawn in penalties to the IRS.

Schofield is hardly alone in approaching his RMD deadline unawares: only 13% of 65-year-olds who are still working can correctly identify when RMDs begin, according to a recent survey by Nationwide.

Your RMD is a percentage of your total assets across your retirement accounts, based on your age and life expectancy: this year, if you’re 70 ½ and have $200,000, it’s $7,299.27; if you’re 76 with a $200,000 pool of assets, the figure is $9,090.91. The IRS has a worksheet to help you calculate your RMDs, and various financial institutions have online calculators.

How you take RMDs can greatly affect how much you end up owing in taxes at the end of the year. If you don’t plan carefully, RMDs can bump you into a higher tax bracket, when combined with your other income sources. They can also affect how much of your Social Security income gets taxed.

Therefore, the more you can control the size or timing of your RMDs, rather than simply following the formula that the IRS provides, the better.

It’s essential to begin planning in advance. By the time you reach Schofield’s age and start getting those notifications that it’s time to take an RMD, you have few options to tailor your withdrawals to your particular needs. “The biggest need we see is the need to be proactive instead of reactive,” says Neil Teubel, director of financial planning at Balasa Dinverno Foltz in Chicago.

Your circumstances will help guide your strategy:

If you’re still working, and deferring withdrawals is important

It’s not possible to eliminate the tax burden altogether--that is, unless you donate your RMD to charity--but it is possible to postpone the requirement to take required minimum distributions under certain circumstances. For instance, if you're still working and your employer’s 401(k) fund permits this, you don’t have to start taking distributions from that pool of assets, as long as you don’t own more than 5% of the company. (You will have to begin withdrawals as soon as you retire, or possibly if you shift to working part-time.)

Monica Dwyer, a certified financial advisor with Harvest Advisors in West Chester, Ohio, suggests this is an excellent strategy. One of her clients, a doctor, took a million-dollar IRA and rolled it over into his current 401(k) this way. “It made sense, since if he had begun taking distributions at 70 ½, his tax rate would have been much higher on that income than it will be when he eventually retires.”

If you have multiple IRA accounts, this requires advance planning: you can only roll over a single IRA per year, and you can’t do it at all after 70 ½.

Roth accounts also offer plenty of flexibility, since the money you withdraw from them is post-tax. Roth IRA accounts are not subject to RMD rules while the owner is still alive, but note that the RMD rules do apply to Roth 401(k) accounts.

Erin Itkoe, a senior wealth counselor with Versant Capital Management, suggests that workers inquire whether their companies offer the option of Roth 401(k) plans alongside the traditional retirement vehicles. If so, she notes, it can make sense to take a “hybrid approach” and contribute assets to both, whether or not you plan to keep working after retirement.

If you’re retired, but still under 70

While you can't eliminate your tax burden unless you donate your withdrawal, it is possible to reduce your tax bill if the timing is right. Say you have only traditional IRAs, either because you have wanted or needed those up-front tax benefits, or because you have earned more than the current income limits for creating a Roth IRA outright (for 2018, that limit is $199,000 for a married couple filing jointly and $135,000 for a single person.) It’s still possible to transfer all or part of those IRA assets into a Roth IRA via a conversion. In this scenario, you pay incomes taxes on the full amount. These conversions are a big part of the toolkit available to financial advisors trying to help clients manage RMDs.

This strategy works particularly well for savers who have already retired and now are earning less income and paying lower tax rates than when they were working full-time. “The mid- to late-60s is the sweet spot to start doing these conversions, for those who want to have some flexibility in how much they withdraw from their retirement assets later on,” says Itkoe. That's because these years are often the ones in which incomes temporarily dip to their lowest levels, so you’ll be in a lower tax bracket than you will be by the time you start withdrawing some of that income at 70 ½.

If you’re still employed and/or have different income streams

You can also reduce your RMDs by strategically reducing the amount you contribute to tax-deferred IRAs and 401(k)s and increasing the amount you contribute to taxable accounts and health savings accounts. Say you are in your late 60s or early 70s, but still working part-time, collecting Social Security, with some investments held outside your retirement accounts as well as some IRAs and your 401(k). Financial advisors like Timothy French, client service director at Altair Advisers in Chicago, emphasize the importance of keeping retirement assets in different buckets to take advantage of the fact that the tax rate charged on ordinary income, which includes RMDs, now stands at 37% for those in the top tax bracket, whereas you pay only 23.8% on capital gains or dividends from your regular investment accounts. At some point, French suggests, it might make sense for you to stop putting money into a tax-sheltered vehicle, which you will withdraw at a highly taxed rate, and instead invest in a normal, taxable account, where you will be taxed only on the gains, and even then at a lower rate.

Advisors say health savings accounts are an excellent bucket for retirement income, although only those with qualifying high-deductible health insurance plans are eligible to open one. You contribute pre-tax money to these accounts, which then grows tax-free. Withdrawals to pay for qualifying medical expenses, such as Medicare premiums, prescription medications, or home health aides, also are free of tax. As long as you’re in a position to create an HSA, it will help ensure you can withdraw money for certain retirement spending needs without ever needing to consider the impact on your taxable income or tax bracket.

If you can afford to bid farewell to your RMDs

Generally speaking, the only way to eliminate your tax burden altogether is to donate your RMD to a qualifying non-profit institution. Indeed, if you happen to be charitably minded, one of the few last-minute strategies to avoid taking an RMD that you don’t need, and paying taxes on it, is to direct your RMD to a charitable organization in the form of a qualified charitable distribution. You get the happiness of contributing to your favorite philanthropic cause and the joy of avoiding a tax bill. There’s a limit of $100,000 annually that can be donated in this fashion.

Another option for those who don't need their RMD to live on? Larry Ginsburg, a financial advisor in Oakland California, reminds retirees that they can invest it for the benefit of others in their family and still shelter it from taxes. All you need to do is set up a 529 plan for the education of a child or grandchild, and while you will still owe your tax payment on the RMD, that contribution will once again accumulate free of tax after it's placed into the 529.

At least Schofield found one way to make his first RMD less onerous than he might have expected. Instead of taking a small distribution from each of four IRA accounts, he decided to close one of them, a small account, whose assets roughly equaled the total of what the IRS wanted him to withdraw this year. That will simplify his bookkeeping going forward, and makes his accounting slightly easier this year.

Correction: An earlier version of this story incorrectly stated that Roth 401(k) accounts are not subject to RMDs, when in fact the RMD rules do apply to Roth 401(k) accounts. The earlier version also misspelled Neil Teubel's last name and misstated the name of the firm Altair Advisers.