The Hidden Tax Trap Awaiting Retirees — and How to Avoid It
Planning for retirement involves saving a nest egg large enough to cover your expenses, but it also involves being smart about taxes.
That’s why it’s important to understand that required minimum distributions (RMDs) — mandatory withdrawals from your tax-deferred retirement accounts like 401(k)s and individual retirement accounts (IRAs) — will affect your tax return. Here’s what you need to know, and how you can reduce your tax burden.
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What you need 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 age, your RMD increases.
Withdrawals from traditional retirement plans are often treated as ordinary income, meaning they may push you into a higher tax bracket. It’s important to consider all of your income when preparing your taxes, including RMDs, dividends and payments from Social Security and pensions.
Your income may also affect if you have to pay taxes on your Social Security payments, and how much. The amount you’ll have to pay in federal taxes on Social Security depends on your “gross income,” which includes adjusted gross income, untaxed income and a portion of your Social Security benefits.
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How to reduce your RMD tax burden
Although RMDs are subject to tax, there are strategies you can use to reduce your tax burden. Here are four to consider.
1. Distribute to the deserving poor
People age 70½ or older can make qualified contribution distributions (QCDs) from their taxable IRAs instead of taking RMDs. These contributions do not count toward taxable income, meaning you can reduce your income to put you in a lower tax bracket.
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2. Do a Roth conversion
Roth retirement plans are not eligible for RMDs and allow you to grow your nest egg tax-free. Another option is to use a Roth conversion to move traditional retirement funds into Roth accounts — though you’ll have to pay tax on the converted amount in the year you convert. You should carefully consider your tax situation and, if possible, discuss the move with a financial advisor before moving forward.
3. Withdrawing from 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 reduce your taxable income, grow the account tax-free and withdrawals are tax-free as long as they are for qualified medical expenses. They have no RMDs and can help reduce your overall tax burden later in life.
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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 reducing your account balances and future RMDs. Just remember, withdrawing your money early means it will miss out on potential growth in the years to come.
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