Reducing the Burden of RMDs in January: A Pragmatic Approach
Many folks preparing for retirement often utilize retirement plans such as a 401(k) or IRA while they're still employed. The major advantage here is that you can deduct your contributions from your taxes for the year you make them. This extra cash contributes significantly to your retirement savings. Your investments won't be taxed until you withdraw money from the account later on.
However, Uncle Sam eventually wants his portion of the money. This is why the government introduces required minimum distributions, or RMDs, for retirees once they reach a particular age (currently 73). If you inherit an IRA from someone who was already subject to RMDs, you'll become subject to these distributions, too.
The law usually demands that withdrawals are made before the end of each calendar year. But there can be some benefits to handling this in January instead. Here are the essential factors to consider.
Understanding RMD Calculations
Before delving into the merits of taking your RMD in January, it's crucial to grasp how these calculations are made. Your required minimum distribution depends on two factors:
- Your account balance(s) at the end of the previous year
- The age you'll reach this year
The IRS uses a life expectancy factor table, which inherently indicates how long the average person your age is expected to live.
If your sole beneficiary for the account is your spouse, and they're ten years younger than you, your RMD will be determined using a joint life expectancy table that depends on both ages. This will result in a reduced RMD.
Extracting Advantages by Taking a Distribution in January
If you aim to decrease your RMDs, it can be accomplished solely by reducing the balance in your account at the end of the year. It would, of course, be counterproductive to avoid investing in the market simply to save money on taxes. However, pulling out your RMD earlier in the year could result in a smaller account balance by year-end, given that there will be fewer assets to appreciate throughout the rest of the year. This, in turn, leads to a lower RMD the following year.
This technique presents significant benefits for those who have RMDs that surpass their expenses but wish to pass assets to their heirs. Withdrawing earlier in the year and reinvesting the surplus RMD in a taxable brokerage account manifest into a very tax-efficient inheritance for your loved ones. Upon your demise, these assets will appreciate a "step-up in cost basis," effectively abolishing the taxes they would have had to pay on the capital gains.
If you gave them the assets in an IRA, they'd need to withdraw their own RMDs and bear the taxes each year. Plus, with a few exceptions, they'd have to exhaust the account within ten years.
Implementing Roth Conversions
Another incentive for taking your RMD in January is that you can't execute Roth conversions until you've completed your RMD. With historically low tax rates slated to expire at the end of the year, this could be the last chance for some to leverage these extremely low tax brackets.
Performing Roth conversions earlier in the year can be advantageous. As assets generally tend to appreciate with time, you'll likely be able to convert more shares or bonds in January when their prices are lower, assuming the market appreciates throughout the year.
When you make a Roth conversion, these assets become exempt from income taxes permanently. Even if you pass these assets on to your heirs, they won't have to pay taxes on the distributions. Moreover, Roth IRAs are not subject to RMDs, enabling you to reduce future RMDs from your traditional retirement accounts.
Should You Take Your RMD in January?
These factors may not have a significant effect on your financial plans or tax strategy. But if you don't intend to reinvest your RMD in a taxable brokerage account and expect to utilize the entire distribution for your living expenses, taking your RMD in January rather than November or December won't bring about considerable changes.
Nonetheless, it's worth noting one vital benefit for almost everyone. By withdrawing in January, you'll have immediate access to this money. This can provide you with financial safety during emergencies. In worst-case scenarios, your beneficiaries won't have to stress about government repercussions for ignoring or postponing your RMD from your account. This peace of mind may be more valuable than advanced tax planning techniques.
In the context of retirement planning, if you're looking to reduce your future required minimum distributions (RMDs), you might consider taking your RMD earlier in the year, such as in January. This could result in a lower RMD the following year due to a lower account balance by year-end. Additionally, if you're subject to required minimum distributions after inheriting an IRA and aim to pass assets to your heirs, withdrawing earlier in the year and reinvesting the surplus RMD in a taxable brokerage account can result in a tax-efficient inheritance for your loved ones.
