- You may not need your RMDs to fund your retirement expenses, but you're still required to take RMDs out of certain retirement accounts beginning at age 70½.
- After you cover expected expenses, consider reinvesting RMDs in nonretirement accounts or donating to charity.
- Avoid IRS penalties and don't miss the deadline to take your RMD.
You've saved for years to get to retirement and now that you're no longer working, it's time to dip into those savings—even if you don't really need to. Once you reach age 70½, the IRS mandates you to take required minimum distributions, or RMDs, each year from traditional IRAs or employer-sponsored retirement accounts.1
"Making the best use of your RMDs can help avoid costly mistakes," advises Ken Hevert, senior vice president at Fidelity. "If you don't plan to use that money for current living expenses, there are some key decisions to make—whether you want to reinvest it, give it to your heirs, or donate it to a charity."
It's important to keep in mind that RMDs are usually taxed as ordinary income. This means that withdrawals will count toward your total taxable income for the year. They will be taxed at your applicable individual federal income tax rate and may also be subject to state and local taxes.
However, if you made after-tax contributions, part of the distribution may be nontaxable.2 While Roth IRAs don't have RMDs during your lifetime, RMDs are required for Roth 401(k)s, though the distributions are typically not taxable (see IRS chart).
RMDs can be an important part of your retirement income plan, but they come with some strict rules, so having an RMD strategy can help. If you have assets that are subject to RMDs, here are 4 key questions to answer that can help you think through how and when to use your RMDs.
1. Do you need the money to cover living expenses?
If you need RMDs to pay for current expenses, it makes sense to develop a budget in retirement. Going through the budgeting process can help you estimate living expenses, manage your cash flow, and determine if you'll need to use your RMDs to fund your retirement lifestyle.
Read Viewpoints on Fidelity.com: Budgeting tips for retirees
"Some retirees will need RMDs to cover their ongoing retirement expenses. If you're planning to spend your RMDs, one big consideration is managing your cash flow," explains Hevert. "You may want to consider having the money sent directly to a cash management or bank account that provides helpful cash management tools."
Ways to withdraw your RMD
You can opt to take one-time distributions for your RMDs year after year, but the easiest way to satisfy your RMD is by setting up automatic withdrawals. This way, you avoid the potential consequences of forgetting to take your RMD. Distributions can be in the form of a check sent to you, a transfer to your bank, or the funds can easily be moved directly into your nonretirement account (brokerage or cash management account). You choose when you want to receive the funds, monthly or annually.
Regardless of the schedule, the deadline is important. You have until December 31 each year to take your RMD.3 The IRS penalty for not taking an RMD, or for taking less than the required amount, is steep: 50% of the amount not taken on time.
Tip: Many people choose to have taxes withheld from their RMDs. If you choose not to do this, make sure you set aside money to pay the taxes, and be careful, sometimes under-withholding can result in a tax penalty.
2. Do you plan to reinvest the money?
For some retirees, pension and Social Security income may cover your expected expenses. Remember, even though you may not need RMD monies to fund your retirement spending, you're still required to take RMDs out of your applicable retirement accounts.
Although your RMD can't be reinvested back into a tax-advantaged retirement account, here are 3 options to consider for your taxable brokerage accounts:
- Municipal bonds or municipal bond funds. These pay income that is generally free from federal income tax and, in some cases, from state and local taxes. Note: Income from some municipal bonds and mutual funds is subject to the federal alternative minimum tax.
- Exchange-traded funds (ETFs) and tax-managed mutual funds. The unique structure of many ETFs may help investors by enabling them to delay realizing taxable capital gains. Tax-managed stock mutual funds as well as equity index mutual funds also tend to be tax-efficient (though there are exceptions).
- Stocks you intend to hold longer than a year that pay qualified dividends. Sales of appreciated stocks held more than a year are taxed at lower long-term capital gains rates. Just be sure any dividends the stock pays are qualified. Qualified dividends are taxed at the same low rates as long-term capital gains, but nonqualified ordinary dividends, such as those paid by many real estate investment trusts (REITs), are taxed at ordinary income rates.
Tip: If you have investments in your retirement account that may be difficult to sell, consider transferring them in-kind to a nonretirement account. This helps satisfy your RMD (you'll still owe the taxes on the distribution), but this option allows you to stay invested in the security. The cost basis on the investment in the taxable account will be reset on the day of the transfer.
Read Viewpoints on Fidelity.com: How to invest tax-efficiently
3. Do you plan to pass money on to your heirs?
If you have grandchildren that you'd like to help give a head start, consider using your RMD to fund a 529 college savings account or Roth IRA for Kids account. Another way to pass money to the next generation is to convert some of your traditional IRA assets to a Roth IRA. With this "Roth conversion" strategy, you'll no longer have to worry about RMDs on the amount converted, because RMDs are not required during the lifetime of the original account owner in a Roth IRA.4
Here's how it works: Say Susan hypothetically had a traditional IRA and wants her 3 children to inherit the bulk of her estate. When she converts her traditional IRA to a Roth IRA, she'll pay taxes on the conversion, reducing the size of her estate.
Her Roth IRA is not subject to any additional taxes (assuming Susan has had a Roth IRA for 5 years and doesn't make any nonqualified withdrawals) or to RMDs. Upon her death, her children would inherit their share of her Roth IRA—income tax-free.
Later on, Susan's heirs will have to take RMDs on their inherited Roth IRA each year after they inherit the account. As long as the distributions are qualified, they won't be taxed on those distributions, which potentially increases the after-tax value of their inheritance.
Remember, if you're already over 70½, you will have to take an RMD before you can convert to a Roth IRA. The upside is that you can then use the amount withdrawn to pay the taxes due from the conversion. However, if you anticipate that your heirs will be in a much lower tax bracket than your own, it may not make sense to convert.
While Roth IRAs are generally not subject to income tax, they are still subject to estate tax, so it is important to plan accordingly. Since there are other ways to transfer money to heirs, such as trusts and gifting, consult an estate planning advisor before making any decisions.
4. Do you want to make charitable donations now?
If you have to satisfy an RMD and you would also like to make a gift to charity, then consider a qualified charitable distribution (QCD). You may be able to kill 2 birds with one stone.
A QCD is a direct transfer of funds from your IRA custodian, payable to a qualified charity. Once you've reached age 70½, the QCD amount counts toward your RMD for the year, up to an annual maximum of $100,000. It's not included in your gross income and does not count against the limits on deductions for charitable contributions. These can be significant advantages for certain high-income earners.
Due to changes enacted by the Tax Cuts and Jobs Act, a number of retirees may now take the standard deduction when filing taxes ($12,000 for singles; $24,000 for couples). For some, it may not make economic sense to itemize deductions on their taxes because they may not be able to get a tax deduction for a conventional charitable contribution. In such cases, QCDs—which do not depend on itemization—may be a useful alternative.
Tip: You don't have to wait until year-end to have a charitable planning discussion with your financial advisor. Once you reach age 70½, you can do a QCD at any point throughout the year. Remember, your QCD amount will not count as an itemized deduction. The rules are complex, so be sure to consult your tax advisor. Get more information about qualified charitable distributions.
Have a plan
Whichever scenario applies to you, RMDs are likely to play an important role in your finances in retirement. Building a thoughtful retirement income plan can help you use RMDs in the most effective way, and help you reach your important financial goals. At the very least, it's important to spend some time understanding RMDs and your options with a tax professional, to ensure that you are meeting the IRS requirements—and to help avoid a costly tax mistake.