How to Use Your Required Minimum Distributions (RMDs) Strategically

A Required Minimum Distribution (RMD) is the minimum amount of money that individuals with tax-advantaged retirement accounts are required to withdraw. RMDs are required to begin no later than April 1st the year following the calendar year in which you turn 72 (or 73 if you reach age 72 after December 31, 2022). RMD rules are in place to ensure that people don't use these tax-advantaged accounts solely as a way to defer taxes indefinitely and that they begin to withdraw the funds and pay taxes on them.

RMD rules typically apply to tax-deferred retirement accounts, including traditional IRAs, 401(k) plans, 403(b) plans, and other similar retirement savings accounts. Roth IRAs, on the other hand, do not require RMDs during the account owner's lifetime because they operate under different tax rules and principles.

The specific amount of your RMD is calculated based on the fair market value of your IRA at the end of the previous year and a distribution factor provided by the IRS based on your age. The formula typically involves dividing the account balance by the distribution factor.

Failing to take your RMD or taking an insufficient RMD can result in substantial penalties. Prior to 2023, the IRS could impose a 50 percent excise tax penalty on the amount that should have been withdrawn. With the passing of the SECURE 2.0 Act, this excise tax amount has been decreased to 25 percent, possibly 10 percent if your RMD is corrected timely within 2 years.

It's important to note that the penalty reduction provided by the SECURE 2.0 Act is effective for RMDs in 2023. It does not apply to missed RMDs in prior years.

The amount you withdraw as an RMD is subject to income tax in the year you withdraw it. When you take your RMD, it will be added to your taxable income for the year and will be taxed at your personal federal income tax rate.

Offsetting income from RMDs with tax loss harvesting involves strategically selling investments with capital losses in taxable accounts to offset the taxable income generated by RMDs. To put it simply, this means you're selling investments that aren't doing well in your regular investment accounts and using those losses to lower the taxes you owe on your RMDs. This allows you to take advantage of investments that have lost value to reduce the taxes you have to pay on the money you're required to withdraw from your retirement accounts. It's a way to be more tax-efficient and potentially save money.

One of the primary purposes of RMDs is to provide a source of income to cover your everyday living expenses in retirement. You can use your RMD to pay for housing, utilities, food, healthcare, and other essential costs. You can also use it to fund discretionary expenses such as travel, entertainment, hobbies, and other activities that enhance your retirement lifestyle.

If you don't immediately need the money from your RMDs to cover expenses, you can reinvest the funds into taxable accounts. This allows your money to keep growing, and you can potentially generate additional income or save for future needs. You could also reinvest your RMDs into tax-efficient accounts or assets to minimize your tax liability and maximize after-tax returns.

You can also use your RMDs to give monetary gifts to charity and family members. However, keep in mind that there is an annual limit that you can gift to an individual tax-free. The 2023 gift tax limit is $17,000. Any amount over this will either be subject to taxes or will count toward your lifetime gift tax exemption.

There are some ways that you can use your RMD strategically. Generally, we like the idea of deferring taxes as long as possible. Why pay them before you really have to? There will be times when you can start to take some distributions a little early, but that will be completely dependent on your financial plan, with a clear understanding of your income and tax picture.

Additionally, you can use your RMD to your benefit regarding your taxes. For example, if you're in a low tax bracket now and the RMD will put you into a significantly higher bracket, then it may make sense to start taking some distributions a little early. Or, if you're in a high tax bracket and have charitable intentions, you can make a Qualified Charitable Distribution (QCD), which counts toward your RMD. Although you cannot make a QCD directly to your Donor Advised Fund (DAF), you can use the QCD to make a gift directly to that organization, which is a great way to lower your taxable income and enhance your tax position.

Generally, the markets are upward-sloping and grow over time, so the longer you can keep your capital invested, the better. If you need to use the RMD money to cover living expenses, you can take a distribution on a monthly basis and allow the remainder to stay invested, generating income and return. If the capital is not needed on a monthly basis, you will likely be better served to defer it until near the end of the year so that the capital generates interest and return tax-deferred.

There are a number of ways to strategically incorporate your RMDs into your financial plan and help you reach your retirement goals. To learn more about RMDs, contact your advisor. Or, if you're interested in talking with a Chicago Partners advisor who can help you optimize your strategy for using your RMDs, you're always welcome to contact us using the form here.