Susan’s new financial planner just gave her shocking news. Because of her age, she has to start taking minimum distributions (i.e., withdrawals) from her traditional IRA this year, and because the money in that account is both taxable and considerable, that “minimum distribution” may cause Susan maximum pain when it comes time to settle up with the IRS.
What can retirees do to avoid this problem?
Let’s dive in. First…
What is an RMD–and why can that be a problem?
RMD stands for “required minimum distribution.” RMDs work like this: If you have money in a traditional Thrift Savings Plan (TSP) or traditional IRA, the IRS stipulates that you must begin withdrawing money from that account when you reach age 73 (if you were born in the years 1951-1959) or by age 75 (if you were born in 1960 or later). The “minimum” you have to withdraw depends on your life expectancy and the amount in the account. These required distributions are taxable.
What our Christy Capital team finds in working with federal employees is that many people retire and reach those prescribed ages, but don’t need to take those distributions for their living expenses.
What’s more, they don’t want to take those distributions, because sometimes, that extra taxable “income” can push them up into a higher tax bracket. Consequently, if there are ways to reduce their RMDs, many people consider that a smart thing to do.
The good news is that there are ways to reduce your RMDs.
Option #1: Start doing Roth TSP or Roth IRA contributions
Instead of continuing to amass a huge balance in your traditional TSP (or traditional IRA), this strategy attempts to have you reach age 73 or 75 with a smaller amount in your traditional accounts.
The easy and obvious way to do this? Simply quit contributing to your traditional account. Instead, contribute to a Roth account. This takes advantage of the fact that Roth TSPs and Roth IRAs do not require a minimum distribution. Roth accounts can continue to grow tax-free, as long as you play by IRS rules while you’re alive and, for a time, even after you leave that money to a beneficiary.
So, the first way to reduce RMDs is to start contributing to the Roth options that you have.
Option #2: Start doing Roth conversions
A Roth conversion is where you take some of the money already in your traditional TSP (or IRA), move it over into a Roth account, and go ahead and pay the taxes owed on it now. This is a strategy we help lots of our clients use. It’s highly effective in reducing RMDs later in life.
One caveat here is that you cannot do this inside your TSP. If you want to convert some of your TSP money, you first have to move that money out of your TSP and into a traditional IRA.
There are two key timeframes when you can do this. The first is if you’re still working and are at least 59 and a half years old. Meet those qualifications and you can move your TSP money out into an IRA–yes, even while you’re working. Then, from that IRA, you can start doing the Roth conversions you desire.
The other window is when you retire or “separate from service.” If you’re no longer a federal employee, it doesn’t matter what age you are. You have full access to your TSP account, and you can roll that money into an IRA.
Following a systematic strategy of shifting money like this year after year can mean that you reach age 73 or 75 (whichever applies) and discover you have a very manageable amount in your account. That means your RMDs will not be too large. You may even have no money left in your traditional account, which means you would have zero required minimum distributions.
Option #3: Use a Qualified Charitable Distribution (QCD)
This is where–if you’re at least 70 and a half years old–you can make gifts to charity directly from your traditional IRA and not pay taxes on that money.
In short, if you’re being told you have to take a sizable RMD from your traditional account, but (a) you don’t need the money, and (b) you don’t want to be saddled with more taxes, you can give that money to your church or favorite non-profit and not owe taxes on it.
The caveat here is that, once again, your TSP will not let you do this. (I don’t know if you’re starting to pick up on this theme, but a TSP doesn’t give you the flexibility to make these kinds of tax-saving moves. Again, if you want to give directly to charity, that money has to come from an IRA, not from your TSP.)
To recap: To reduce your RMDs (and potentially, your tax burden) down the road, you need to reduce the balance in your traditional TSP or traditional IRA. Letting it grow year after year–from age 60, let’s say, up to age 75–can result in a really large balance, and complicate your life.
You can address that potential problem now by making future contributions to a Roth account and/or by a strategy of Roth converting your traditional funds over time. This will shrink your traditional balance and grow your Roth balance. Remember: Roth accounts don’t require a minimum distribution like the traditional balances.
You may be thinking, “Those are smart strategies, but am I too late to do Roth?” If so, check out this video, “Is it too late to start Roth TSP?”
Or, if you wish to be philanthropic, you can avoid the RMD problem altogether by deciding to use the money in your traditional TSP money for charitable giving through a QCD.
