You saved for years to get to retirement—contributing to a traditional 401(k) or IRA. Now it’s time to dip into those savings—even if you don’t really need to. Because you got a tax break when you contributed to these accounts, once you turn age 70½ the IRS requires you to withdraw every year from your traditional IRA or employer-sponsored retirement plan account, such as a 401(k) or 403(b), and start paying taxes on that money.1 It’s important to determine how these minimum required distributions—known as MRDs or RMDs (required minimum distributions)—fit into your retirement income plan.
“Making the best use of your MRDs can help avoid costly mistakes. If you don’t absolutely need that money for living expenses, you can make some decisions about the best way to use it,” says Ken Hevert, Fidelity senior vice president of retirement products.
You do have some flexibility on timing and what to do with the money. For instance, if you don’t need it for living expenses, you may want to give it to your heirs, donate it to a charity, or reinvest it.
It’s important to keep in mind that MRDs are usually taxed as ordinary income. However, if you’ve made after-tax contributions to these accounts, part of the distribution may be nontaxable. MRDs are required for Roth 401(k)s, but the distributions are not taxable. Roth IRAs do not have MRDs during your lifetime.
Here are four key questions that can help you come up with an MRD strategy.
|1.||Do you need the money to cover living expenses?|
“If you’re planning to spend your MRDs, 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 easy access to it.”
The clock is ticking on taking your MRD—you have until December 31 each year to take your withdrawal.1 The IRS penalty for not taking an MRD, or not taking enough, is pretty steep: 50% of the amount you should have taken. Having the money automatically distributed to a bank account, cash management, or taxable brokerage account may help ensure that your MRD requirement will be met by the deadline.
When planning your budget for the year, bear in mind that you’ll generally owe income tax on any MRDs and other distributions from traditional retirement accounts. You can have taxes automatically withheld from your MRDs. If you choose not to do this, make sure you set aside money to pay the taxes, and be careful. Sometimes underwithholding can result in a tax penalty.
Ways to withdraw
There are a few different withdrawal methods that you may want to consider to help you meet your MRD requirement:
Annual recalculation: This approach generally requires annual distributions from your account based on your life expectancy. The MRD amount is recalculated each year. You can choose how and when you want to receive the funds—for instance, monthly, annually, or on a schedule you choose.
Purchase an income annuity: Purchasing an annuity with the money in your IRA can turn it into a stream of income payments that’s guaranteed2 for life—and it takes care of MRDs at the same time.3 (There are a number of limitations on the types of annuities that can be used to satisfy MRDs, so be sure to check with a tax professional.) Additionally, only the amount used to purchase the annuity may satisfy your MRD requirement. If you have other IRA accounts, you will still need to meet required distributions for them.
Annuities have advantages—most eliminate the need to worry about outliving your money, for one—but also drawbacks, such as the loss of access to your principal. Weigh the purchase of an annuity carefully, and do so in the context of a broader retirement plan. There are two payment options:
- Fixed payment option. Lifetime payments remain level—although you may choose to pay extra for a cost-of-living adjustment (COLA) to increase payments annually and to help hedge against inflation. However, access to additional principal withdrawals is limited. You could also use a Qualified Longevity Annuity Contract (QLAC) to defer payments on a portion of your pretax assets up to age 85 without conflicting with MRD rules. This could help cover expenses such as health care later in life. Read Viewpoints: “A way to secure retirement income later in life.”
- Variable payment option. Lifetime payments vary over time, based on the performance of the underlying investments you choose. In some cases, additional withdrawals after purchase may be allowed.4
|2.||Do you plan to reinvest the money?|
If so, you may want to consider depositing MRDs in a nonretirement account. You can then invest the money according to your goals, time horizon, risk tolerance, and financial circumstances.
If you choose to invest your MRDs in a taxable account, you may want to consider owning tax-efficient securities to help potentially reduce your tax liability. These could include:
- Municipal bonds and municipal bond funds. These pay income that is 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.
- Stocks you intend to hold longer than a year that may 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.
- 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 and other tax-efficient stock mutual funds, which trade infrequently and may use other techniques that seek to reduce a shareholder’s tax liability. You may want to consider owning less tax efficient investments, like taxable bond funds, REITs, or dividend-paying stocks in tax-advantaged accounts like IRAs or tax-deferred workplace savings accounts.
Remember to choose an investment mix that reflects your financial situation, time horizon, and risk tolerance. “Know what the purpose of the money is, how long until you’ll need it, and how much risk you’re willing to take—and invest accordingly,” advises Hevert.
- Read Viewpoints: “How to invest tax efficiently.”
|3.||Do you plan to pass money on to your heirs?|
If so, you may want to consider converting traditional IRA assets to a Roth IRA. The benefits of this strategy are that you’ll no longer have to worry about MRDs, and distributions from a Roth IRA are not taxable.5 One drawback is that you’ll have to pay taxes on the amount converted—but that may be mitigated by any nondeductible contributions you’ve made to any IRA, even if it’s not the one being converted. Before you decide, consider the tax rate your heirs will pay on inherited assets. If your heirs will be in a much lower tax bracket than your own, it may not make sense to convert. Of course, this is an important decision, so check with your financial, estate, or tax advisor.
Because a Roth IRA has no MRDs during the lifetime of the original owner, you can leave the money in place for as long as you live, with the potential to generate tax-free growth. Your heirs will have to withdraw an MRD (because they aren’t the original owner) each year after they inherit the account, but they generally won’t be taxed on those distributions, which potentially increases the value of your bequest. Read Viewpoints: “Inheriting an IRA? Know the rules.”
Before you can convert to a Roth IRA, if you’re already over 70½, you will have to take an MRD. The upside is that you can then use the amount withdrawn to pay the tax cost of the conversion. Please note that while Roth IRAs are generally not subject to income tax, they are still subject to estate tax, so it is important to plan accordingly.
Of course, there are other ways to transfer money to heirs, such as trusts and gifting, so consult a tax advisor before making any decisions.
|4.||Do you want to make charitable donations now?|
If you want to donate to a charity, you may want to look into a qualified charitable distribution (QCD). A QCD is a direct transfer of funds from your IRA custodian, payable to a qualified charity. An option once you’ve reached age 70½, the QCD amount counts toward your MRD for the year, up to $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, but the rules are complex. Be sure to consult your tax advisor. Get information about qualified charitable distributions (QCDs).
A strategy involving a Roth IRA conversion and simultaneous charitable contributions may advance your philanthropic goals while eliminating the need for MRDs during your lifetime, and could manage the tax consequences of a conversion. It involves performing a Roth IRA conversion, then making a charitable contribution in the same amount as the conversion. In general, the goal is for your donation to help reduce your taxable income by the same amount that the conversion increases it, leaving you with little or no tax impact. You could also make the charitable contribution to a charity that has a donor-advised fund program, and recommend grants to other charities from your donor-advised fund over time.
“This move is driven by the desire to convert to a Roth IRA,” cautions Hevert. “If you don’t have a need for a conversion, you may be better off not converting and simply making a charitable donation.”
Generally, anyone who has large charitable intentions may not want to convert to a Roth IRA. Typically, the most tax-efficient account to leave to charity at death is a traditional IRA, because the charity does not pay income tax, and the charitable bequest is deductible against an investor’s taxable estate. Tax planning can be complex, so consult a tax advisor before taking any action. Read more in Viewpoints: “Tax-savvy Roth IRA conversions.”
There are IRS limits to deductible charitable donations, however. The amount you can deduct for charitable contributions cannot be more than 50% of your adjusted gross income. Your deduction may be further limited to 30% or 20% of your adjusted gross income, depending on the type of property you give and the type of organization you give it to. A higher limit applies to certain qualified conservation contributions.
Have a plan
Whichever scenario applies to you, MRDs are likely to play an important role in your finances in retirement. Building a thoughtful retirement income plan can help you use MRDs 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 MRDs and your options with a tax professional, to ensure that you are meeting the IRS requirements—and to help avoid a costly tax mistake.
- For Fidelity retirement accounts, consider setting up automatic MRDs (login required).
- View your MRD calculation estimate and the year-to-date distributions for your IRAs and small-business retirement accounts in the Retirement Distribution Center (login required).
- Need a primer on MRD basics? Watch “Making Sense of MRDs.”
Before investing, consider the investment objectives, risks, charges, and expenses of the fund or annuity and its investment options. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.