Money matters | Reducing taxes from annual RMDs

My client Sam decided to retire in a year. He looks forward to pursuing a number of interests. But one thing troubled him. “Three words,” he said. “Required minimum distributions.”

Sam’s investment portfolio will provide a nice income when he leaves work. It includes a hefty individual retirement account. But Sam knows that beginning the April he turns 701/2, he is required to withdraw a required minimum distribution (RMD)  every year.

The RMD comes as no surprise. Decades ago, Washington made a deal with the American people: Contributions to a traditional IRA or similar retirement account like a 401(k) are tax-deductible. Moreover, income generated by a traditional IRA is tax-deferred. It’s a good deal, enabling traditional IRA accounts to grow larger.

“But there’s no such thing as a free lunch,” I reminded Sam. “When you withdraw funds from an IRA, you treat them as ordinary income and pay taxes at whatever your rate is.”

What’s more, you have to withdraw funds from your traditional retirement accounts. By the April after you turn 701/2, you must withdraw that minimum each year.

“So the government wants to collect taxes one way or another,” Sam said.

“That’s right,” I responded. “But there are strategies for minimizing the taxes you pay to keep more of what you saved.”

The first was made permanent in 2016 for a qualified charitable distribution.

Sam looked puzzled. “You mean, just take money out of my IRA and later donate it to a charity?”

That’s not the most tax-efficient way to do things, I explained. You’ll have to pay taxes on your required minimum distribution. And the deduction on your gift will only save you so much. Consider this:  You as an individual donor are allowed to transfer your RMD to a qualified nonprofit/charitable organization. The cash goes directly from your retirement account to the organization. So you pay no taxes on your required minimum distribution.

“But I give to charity anyway,” Sam said. “It sounds like a trade-off.”

Not so, I advised. What you receive from your RMD counts as ordinary income. You’ll probably have other taxable income in retirement, so your tax rate is liable to go up and your tax liability with it. By substituting a gift from your traditional IRA for “ordinary” charitable gifts, you can come out ahead.

The best strategy for charitable donations is using appreciating assets outside a retirement account. Talk to your tax adviser. It involves reducing the principal in your traditional IRA by converting some or all of those assets to Roth IRA assets that have no required minimum distribution.

A number of factors are involved, but I’ll simplify. Normally, when you retire, your income drops. That brings down your tax liability, too. If you own a home with a mortgage, you can take Schedule A deductions to bring your taxable income down further. Even if you don’t, you and/or your spouse can delay taking Social Security. (If you do, your Social Security payments will be larger when you eventually receive that income.) By whittling down your income, during the years usually between retirement and 701/2, you create an opportunity to convert traditional IRA assets normally taxable as ordinary income upon withdrawal when your tax rate is high to nontaxable Roth IRA assets that at conversion are taxed at a lower rate.

You’ll pay relatively little in taxes. Then what? With those funds in a Roth IRA you can make withdrawals tax-free anytime you like. Your money can grow faster as tax-free income compounds. And you can leave assets in your Roth account as part of your estate. There’s no RMD.

“Sounds good, but can I handle it myself?” Sam asked.

“It can be complicated, but you can do it with a step-by-step plan.”

I advised Sam to first speak with his accountant before bringing in a financial adviser. Tax planning strategy is a team effort, after all.

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Ira Fateman

Ira Fateman is a certified financial planner at SAS Financial Advisors in San Francisco. He can be reached at (415) 277-5955 or ira@sasdvisors.com.