Updated May 2017 — In your earning years, the rules of retirement accounts aren't too complicated. There are limits on how much you may be able to contribute to certain types of accounts, such as Individual Retirement Accounts (IRAs). But the general rule is to figure out a way to put away as much as you can to prepare for your golden years.
When you get close to or reach retirement, however, everything changes a little. You move into a position where you're likely shifting from saving for retirement to living in retirement or focusing on your estate, and it's important to understand the role of required minimum distributions (RMDs) on your wealth plan.
You are typically required to begin withdrawing money from retirement accounts upon reaching age 70 1/2. One exception is Roth IRAs, which do not have RMDs during the owner's lifetime. Money from RMDs can help you pay for your cost of living in retirement when you're not earning a salary, but a portion of those distributions is usually taxable income. It is crucial to discuss your needs and income sources with your relationship manager and then set a plan for your RMDs.
These three questions may help frame that discussion and lead you to what makes sense for your situation.
1) Should I take my distributions or delay them?
For many investors, one of the first considerations is whether they need RMDs to sustain their lifestyles, says Chris Wrench, a Wealth Planning Strategist for Wells Fargo Private Bank. If that's the case, advisors help them determine how to take the distribution.
Current IRS regulations require individuals to start taking RMDs no later than April 1 following the year they turn 70 1/2. So, if you reach that age in 2016, you have until April 1, 2017, to take your first distribution. However, if you wait until the following calendar year, you will also have to take that year's regular distribution at some point as well, which increases the amount of taxable income you'll be receiving that calendar year.
Higher income can trigger unexpected negative consequences, such as limits on deductions and increases in Medicare insurance premiums and income taxes on Social Security benefits, according to Wrench.
"Many people take the distribution in the first year so they won't owe taxes on two distributions," Wrench says. "Even though they're giving up some tax deferral in the year they reach 70 1/2, it may be preferable to an increase in taxable income and potential loss of some deductions the next year. As every situation is different, we urge our clients to consult with their tax advisors when considering their approach to RMDs."
"If you have the passion and the desire to provide for a particular charity in your planning, then QCDs are a great way to satisfy that passion." — Chris Wrench, Wealth Planning Strategist, Wells Fargo Private Bank
2) Can I use my RMDs to help plan my estate?
If you can comfortably live your life by using savings or investment income that is not subject to RMDs, you may be able to explore more tax-efficient ways to use your RMDs or make changes to your accounts before RMDs kick in.
Parents who plan to pass along wealth to their children typically convert traditional IRAs to Roth IRAs, which aren't subject to required minimum distributions for the original owner, Wrench says. The conversion does trigger taxes for the parents, but not for the children when they eventually access money from it.
"It can be a great estate planning tool," Wrench says. When parents pay the conversion taxes with outside assets instead of assets of the IRA itself, he says, "It's like an additional gift to the kids."
3) Can RMDs be part of my charitable giving strategy?
For qualified assets, such as IRAs, clients often have the primary goal of helping to "maximize tax deferral and find the most efficient use of those funds," says Wrench.
"Making a donation from a tax-deferred IRA is a popular option," Wrench offers. "Qualified charitable distributions (QCDs) allow individuals to transfer as much as $100,000 of IRA savings annually to qualified charities."
The organization must meet IRS qualifications for receiving proceeds of charitable income tax deductions by individuals. Under IRS rules, that excludes private foundations and donor-advised funds. The advantage of QCDs over simply taking the distribution and then making a donation is that, with a QCD, the donation amount does not count toward your adjusted gross income.
"If you have the passion and the desire to provide for a particular charity in your planning, then QCDs are a great way to satisfy that passion," Wrench says.