Make the most of your RMD vacation

With no required minimum distributions, you can save on taxes or pay it forward.

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Key takeaways

  • Required minimum distributions are paused for 2020, so those over 72 may have less taxable income for the year.
  • If you decide to stop your withdrawals, or take out less than would have been mandated, it could significantly change your income tax burden.
  • What you choose to do depends on your overall financial situation.

If you are headed for a significantly lower tax bill in 2020 because you don't have to take money out of your retirement accounts, what are your plans for the sudden savings? You could pocket the difference, or you could pay it forward to yourself and save even more down the road, depending on your situation.

As part of the CARES Act for economic distress caused by COVID-19, Congress put a one-year halt for 2020 on required minimum distributions (RMDs) from tax-deferred retirement accounts like traditional IRAs, 401(k)s, and other qualified accounts that are subject to RMDs. The IRS says that if you had already taken money out before the rule changes and want a do-over, you have until the end of August 2020 to put it back in your accounts.

Typically, Americans 72 or older must make withdrawals from these accounts based on a formula that divides the balance of your accounts at the end of the previous year by a factor based on your age.* The idea is that you put the money into the account before paying taxes on it, and the government wants its tax cut after waiting so long. Fidelity Investments data shows that about 1.8 million personal investing customers are in this phase currently.

Say you're 73 and have about $1 million saved: You'd have to withdraw roughly $40,000 for the year as a required distribution, which will shift over time as you age and deplete the account. You pay income tax on what you withdraw, so this impacts your tax bracket, how much tax you pay on your Social Security benefit and capital gains, and the cost of your Medicare premiums.

"Taking a break from a year of taxes on a sum like $40,000 can be a real cost savings—for many clients, it's $8,800 or more, and that's not counting state and local taxes," says Matthew Kenigsberg, vice president of investment and tax solutions at Fidelity.

What you decide to do in this situation depends greatly on your personal financial situation. Here are some common scenarios.

Do nothing

People usually jump at any offer of tax savings, so the prospect of an RMD vacation can be pretty enticing. If you have enough savings or other resources to get through the year without making withdrawals, you may be able to lower your current tax bill.

"This strategy makes the most sense when you think your tax rate will be even lower in the future, or it will be even lower for the person who will inherit the account after you die," says Mitch Pomerance, CFP® CFA, a Fidelity advisor based in Danvers, Massachusetts.

Tip: If your RMDs were set to withdraw automatically, it's a quick process to turn them on and off, either online or by calling. Log on to your accountLog In Required for details on doing so at Fidelity.

Take what you need

Most people withdraw money from their retirement accounts, regardless of whether the government tells them to, because they live off that money.

For Marilyn Arnold, a 72-year-old from Missouri, the RMD vacation means simply that she can withdraw what she needs and leave the rest alone. "I'm doing a small amount, because my husband has health issues and needs medication," says Arnold, who continues to work at her own design business.

Cut taxes later

With some strategic planning, you could use this year as an opportunity to have less taxable income in future years. One way to do this is with a conversion from a traditional IRA or 401(k) to a Roth IRA or a Roth 401(k).

If you were that 73-year-old who has $1 million saved for retirement, instead of taking an RMD for 2020, you could withdraw $40,000 and invest it in a Roth IRA. You would need to pay income tax on the amount you withdraw.

The amount converted to a Roth grows tax-free, is not subject to required minimum distributions while you're still the owner, and it can be worth more, on an after-tax basis, to heirs who inherit it. A financial professional can help you assess whether you could benefit from this scenario.

"No performance is guaranteed, but if you think your tax rates in later years will be higher than they are now, Roth conversion could help you reduce your taxes in the future," says Kenigsberg.

Read Viewpoints on Roth IRA conversion: 7 things to know

Get even more complex

Depending on your financial situation, there may be more options. If you have little taxable income, but you have investments held in taxable accounts with embedded capital gains which no longer fit in your overall portfolio strategy, you may want to sell some of those off in a year when you have a zero long-term capital gains tax rate. In 2020, for those joint filers, the zero rate on long-term capital gains applies to those with taxable income of $80,000 or below, so for many, skipping the RMD may mean that their incomes are low enough to realize long-term gains without paying capital gains taxes. For singles, the cutoff is $40,000.

You might also want to reconsider your charitable giving strategy. If you normally donate to charity directly from your IRAs (such gifts are called Qualified Charitable Distributions), you may want to pause this year and instead donate appreciated securities from your taxable accounts to charities instead. In general, other things equal, it's best to make gifts from your traditional IRA when your income is relatively high, not when it's down because of the RMD vacation.

Next steps

The bottom line is that somebody is going to have to pay taxes on your tax-deferred retirement accounts at some point—either you or your heirs. You can avoid it this year, but that doesn't make the liability go away. If you need help deciding what's best for your situation, a financial advisor and a tax professional can help you sort out which options to choose.

Next steps to consider

Roth conversion calculator

Understand the potential outcomes that a Roth conversion could have on your financial plan.

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