9 Ways to Trim Taxes and Maximize Benefits from RMDs

Required minimum distributions (RMDs) from IRAs weren’t simplified or changed in the new tax law.

Taxpayers ages 70½ and older still have to take these distributions from traditional IRAs and other qualified retirement plans, 401(k)s included, whether they need the money or not. The good news is we still have strategies to simplify RMDs and reduce taxes on them.

RMDs are taxed as ordinary income at an individual’s highest tax rate. So, missing opportunities to reduce RMDs can be expensive.

More importantly, the penalty for computing your RMD wrong is perhaps the highest in the tax code. You pay 50% of the amount you should have distributed but didn’t. Finding RMD mistakes is a high priority for the IRS. It learned a few years ago that many taxpayers either don’t take their RMDs or calculate them wrong. Now, computers are programmed to identify potential RMD mistakes. You might avoid the penalty in some circumstances. See our July 2017 issue for details.

Managing the RMDs is an important part of retirement and tax planning after 70½. Here are nine RMD
strategies you need to know.

Know the exceptions. Not everyone has to take RMDs from every qualified retirement account after age 70½. Seeour November 2016 issue for details of the exceptions.

Computing RMDs. Most people don’t need to compute their RMDs anymore. Financial services firms
generally are required to send you a statement early in the year that calculates your RMD for the current year.

It is easy to check the calculation or compute the RMD yourself. Start with your IRA balance on Dec. 31 of the preceding year. For 2018 RMDs, use the IRA balance on December 31, 2017. In free IRS Publication 590-B (available on the IRS web site at www.irs.gov), turn to the life expectancy tables in the back. Most people use Table III. A married IRA owner whose spouse is more than 10 years younger
and is the primary beneficiary uses Table II. Beneficiaries use Table I. Look up the life expectancy factor
for your age in the appropriate table. Divide the total IRA value by the life expectancy factor. The result is your RMD for this year. You perform this exercise every year.

You always can take out more than the RMD after age 70½. But you must take at least the RMD amount.

Aggregating RMDs. When you have multiple IRAs, calculate the RMD for each IRA. Then, you can add the individual RMDs to arrive at one aggregate RMD for the year.

You can take the aggregate RMD from the IRAs in any combination you want. Take it all from one, pro
rata from each, or in any other combination you want. Some people use the RMDs to rebalance their overall portfolios. When different IRAs have different beneficiaries, some people use RMDs to equalize IRA values. Some people take all their RMDs from one IRA until it is exhausted, and then move to another IRA. Over time, that simplifies their lives by reducing the number of IRAs.

The aggregation rule applies only to traditional IRAs. You can’t aggregate different employer retirement accounts or inherited IRAs. Their RMDs have to be separately computed and taken.

In-kind distributions. Most people think RMDs have to be cash distributions. They sell assets, perhaps incurring trading costs, and distribute the cash.

There’s no need to sell assets to make RMDs, because distributions don’t have to be in cash. Your IRA can distribute assets.

For example, when your IRA custodian is a mutual fund or broker, it’s usually easy to direct the custodian to transfer shares of a mutual fund or stock from the IRA to a taxable account. Most of the time this can be done through the website or over the telephone. There usually is no fee for the transfer, and your portfolio allocation doesn’t change.

The fair market value of the asset on the day of the distribution is included in your gross income and counts toward your RMD. It also is your tax basis of the asset. So, if you sell it in the future, you owe capital gains taxes only on the appreciation after the distribution.

The in-kind distribution is valuable when your IRA owns unconventional assets, such as real estate, mortgages, or a small business. You might avoid selling the asset by transferring legal ownership of a portion of the asset from the IRA to you. But in some cases, the cost of transferring legal title each year can be burdensome. With real estate, for example, you probably need to have a new title or deed drawn
up and recorded every year.

Another handicap is the valuation. When the asset isn’t publicly traded, you need an appraisal or other method to establish the value. You want to deter the IRS from challenging the valuation and imposing the penalty for failure to take the full RMD.

Timing distributions. The tax law says the IRA must distribute at least the RMD by the close of business on Dec. 31. Other than that, you can schedule distributions however you want.

A few years ago, a study by T. Rowe Price concluded that an IRA lasted longer when RMDs were delayed until late in the year. That’s because a majority of the IRA was invested in stocks, and stocks were in a bull market during the period of the study. Delaying distributions until late in the year let more appreciation compound in the IRA. But if stocks weren’t doing as well, delaying distributions wouldn’t
be as beneficial. Also, the difference would be much less if the IRS distributed
assets that stayed invested in a
taxable account, after paying taxes.

I generally encourage people to
take RMDs early in the year to ensure
nothing during the year prevents a
distribution. Remember, in the year a
person passes away, the RMD still has
to be taken. Often that doesn’t happen
and the estate pays a penalty for not
taking the RMD.

Also, if you convert a traditional IRA
to a Roth IRA during the year, the RMD
still has to be taken from the traditional
IRA. In fact, the RMD has to be taken
before the conversion takes place.

Qualified longevity annuity contracts.
RMDs can be delayed when the
IRA purchases a qualified longevity
annuity contract (QLAC). The portion
of the IRA that is invested in a QLAC
isn’t included when computing RMDs.

A QLAC is a deferred annuity contract.
You give a deposit to an insurer,
and it promises to make a specific
annual payment to you each year for
the rest of your life, beginning in a
year you select. The payments can be
delayed from two years to 45 years after
you buy the annuity, but they have
to begin by age 85.
The QLAC can be used for the lesser
of 25% of your IRAs or $125,000. The
limit is per person, not per IRA. See
our October 2015 issue for details
about QLACs.
If you’re inclined to buy a QLAC, it’s
probably best to move the money into
a separate IRA that owns nothing except
the QLAC. That will simplify your
annual RMDs and IRA management.
The charitable exclusion. The
qualified charitable distribution exclusion
was made a permanent part of
the tax law in late 2015.
A taxpayer age 70½ or older can
have money transferred directly from
a traditional IRA to a public charity.
The distribution is treated as part of
the individual’s RMD for the year, but
it isn’t included in his gross income.
The IRA owner receives no charitable
contribution deduction.
This strategy probably is valuable
to more people after the Tax Cuts and
Jobs Act, because the higher standard
deduction means fewer people will be
itemizing expenses and taking charitable
contribution deductions. The qualified
charitable contribution exclusion
might be the only tax-advantaged way
for some people to make charitable
contributions after 2017.
The qualified charitable distribution
exclusion is limited to $100,000 per
taxpayer per year. See our May 2016
issue for details about the strategy.
Timing the first RMD. The first
RMD has to be taken by April 1 of the
year after you turn age 70½. Technically,
however, the RMD is for the year
you turn 70½. For many taxpayers, it
makes sense to take that first RMD by
Dec. 31 of the year they turn 70½ so
they don’t have two RMDs bunched in
the next year.
Suppose Max Profits turns 70½ in
July 2018. He doesn’t have to take that
first RMD until April 1, 2019. But he’ll
also have to take his 2019 RMD by
December 31, 2019. If he waits until
2019 to take the first RMD, he’ll have
two RMDs on his 2019 tax return.
That could push him into a higher tax
bracket or trigger some of the Stealth
Taxes that kick in at higher incomes.
He might be better off taking the first
RMD by December 31, 2018.
Avoiding the RMD Waterfall. The
first RMD is 3.6% of the IRA balance,
using Table III of the life expectancy
factor tables. The percentage of the
IRA required to be distributed increases
each year. Many people find
that in their late 70s or early 80s, the
RMD rules force them to distribute
and take into gross income far more
money than they need or can spend.
At age 80, 5.25% of the IRA must be
distributed, and at age 85 you must
distribute 6.76%.
That’s why I say the RMD tables create
an RMD Waterfall. The percentage
of your IRA that must be distributed
increases each year. If you’re investing
well, the dollar amount of the RMDs
increases significantly over time. Your
gross income increases more and
more each year. This situation triggers
higher taxes.
People who have sufficient retirement
income and assets outside their
traditional IRAs find the IRA Waterfall
is burdensome.
Fortunately, there are ways to reduce
the IRA Waterfall. We discussed a
number of them in our August 2016
and March 2015 issues.