One of the benefits of saving for retirement using a tax-advantaged retirement account is the ability to defer taxes on money saved, and on the investment gains on those savings. Required minimum distributions (RMDs) is the government’s payback for some of those tax-advantaged gains.
While you can’t generally completely avoid taxes on RMDs, there are ways to reduce or defer the tax impact of RMDs. However, there are generally trade-offs to be considered before going ahead with any of these options.
Contribute to Roth accounts
One way to avoid RMDs and the associated taxes is to contribute to a Roth IRA. Distributions from a Roth IRA are tax-free if the five-year rule on contributions is met and you are at least age 59 ½. Roth IRAs are not subject to RMDs. The trade-off is that contributions to a Roth IRA are made with after-tax funds, so there is no upfront tax benefit as with a traditional IRA contribution.
Contributing to a Roth 401(k) works much the same way, except that Roth 401(k) accounts are subject to RMDs. These RMDs are not taxed, however. RMDs on Roth 401(k)s can be completely avoided if these accounts are rolled over to a Roth IRA account once the account holder leaves their employer.
In the case of Roth IRAs, there are income limits above which contributions cannot be made. The amounts are updated in most years. For 2021, those married filing jointly cannot contribute to a Roth IRA with a MAGI (modified adjusted gross income) greater than or equal to $208,000. For single filers this limit is $140,000. Additionally, the maximum contribution limits for an IRA for 2021 are $6,000, with $1,000 in catch-up contributions for those who are 50 or over. The contribution limits are unchanged for 2022.
Roth 401(k)s do not have a contribution limit based on income. For 2021 the maximum contributions are $19,500 with a $6,500 catch-up limit for those 50 or over. This increases to $20,500 in 2022, plus the $6,500 catch-up for those 50 or over.
In this case working longer can allow you to defer RMDs on money held in the 401(k) or similar retirement plan sponsored by your current employer in some cases. Those who would normally be subject to RMDs on this money can skip taking RMDs for the years in which they are still working if their employer has made the proper election and amended the plan documents accordingly.
If you have RMDs on other retirement accounts such as a traditional IRA, those RMDs still must be taken by the end of the appropriate calendar year, otherwise you will incur a 50% penalty on the amount not taken by the deadline plus still being liable for the taxes.
One tactic that might be available to you is to do a reverse rollover of money in a traditional IRA into your current employer’s plan if they allow this. It’s important that the funds in the IRA consist of money that was contributed on a pre-tax basis and that this money only be rolled into a traditional 401(k) account. RMDs on these rolled over funds can be treated in the same fashion as the money already in the traditional 401(k) account.
An important note, once you leave this employer, this money will be subject to RMDs based on the year-end balance and the IRS factor for the given year.
Charitable donations – QCDs
The rules allow for charitable contributions to be made from traditional IRA accounts by those who are at least age 70 ½. The distributions are called qualified charitable distributions or QCDs. Up to $100,000 can be distributed from the traditional IRA account each year and donated to a qualified charitable organization.
QCDs are not tied to RMDs per say, in fact account holders can give up to the limit even if this exceeds the amount of their RMD. QCDs are not subject to taxes, but there is no charitable tax deduction either. QCDs can be used to make some or all of your RMDs, eliminating federal taxes and state taxes in most cases.
QCDs that are begun at age 70 ½ will serve to reduce the amount of future RMDs in that this will reduce the future balance of the traditional IRA in that these amounts will be out of the account and not part of the calculation of future RMDs. QCDs that exceed the amount of the RMD for a given year have a similar effect.
Roth IRA conversions
A Roth IRA conversion entails converting some or all of the balance in a traditional IRA account to a Roth IRA. The amount converted is subject to taxes at your ordinary income tax rate in the tax year the conversion takes place.
Amounts that pertain to after-tax contributions to the traditional IRA account, if any, would be exempt from taxes. If the conversion is a partial conversion of the traditional IRA account, then the amount of after-tax contributions would be prorated based on the level of after-tax contributions in the account.
After the conversion takes place, the money now in a Roth IRA is not subject to RMDs in the future or any taxes associated with RMDs. A note of caution, if the Roth IRA conversion is done after the account holder has commenced RMDs on the traditional IRA, the RMDs on that account must be taken in full for that year. Doing a Roth conversion does not reduce this amount.
The trade-off here is paying taxes on the Roth conversion and avoiding future RMDs and the associated taxes on RMDs on the conversion amount plus any gains in future years. You will want to do some calculations and analysis based on your anticipated future tax rates and possible returns that could be earned on the converted funds to determine if this tactic is advantageous for you.
Roth 401(k) conversion
This could entail an in-plan conversion if your employer’s plan allows for this. You would take some or all of your balance in a traditional 401(k) account and convert this amount to a Roth 401(k) within the plan, if offered.
Taxes will be due in the current year on the amount converted, with the exception of any after-tax conversions if applicable. The money in the Roth 401(k) will not incur taxes when withdrawn if you are at least 59 ½ and the five-year rule on the conversion has been met.
Another form of converting a traditional 401(k) account to a Roth could occur when you leave the company and choose to rollover your 401(k) balance. You could convert the 401(k) balance to a Roth IRA, again all applicable taxes would be due.
Backdoor Roth IRA conversions
A backdoor Roth IRA conversion is a tactic that is generally used by someone whose income is too high to contribute directly to a Roth IRA. Under this strategy, you would make an after-tax contribution to a traditional IRA and then convert this amount to a Roth IRA.
If you have no other traditional IRA balances, then the conversion could be tax free assuming that the money contributed has not generated any earnings or investment income.
If you have other money in traditional IRAs already then the amount converted would be taxed based on the percentage of the after-tax amount converted to the total amount of traditional IRA money that pertains to pre-tax contributions and earnings on the account(s).
The money converted will not be subject to future RMDs or taxes on those RMDs.
Please note that there is potential legislation that could end the backdoor Roth strategy as early as the beginning of 2022, so be sure to monitor this situation if this is a strategy you might consider.
Mega backdoor Roth
A mega backdoor Roth is a situation where you make after-tax contributions to your employer’s 401(k) over and above your salary deferral contributions. Not all employers allow this in their plan. For those that do, the maximum contribution is $38,500 for 2021.
Depending upon the plan’s rules, this money may be eligible for an in-plan conversion to a Roth 401(k) account. Or if allowed, you may be able to do an in-service withdrawal while still employed and roll this money over and do a Roth IRA conversion. If neither of these options are available, you will generally have to wait until you leave the employer and then do a rollover and Roth IRA conversion.
The only taxes on the converted amount with the mega backdoor Roth would be on any earnings on the money converted. And this money will be exempt from future RMDs and the taxes on those distributions.
The mega backdoor Roth could also be impacted by potential legislation. If you haven’t started down the path with this strategy you will want to monitor developments. If you already have done mega backdoor Roth contributions, you will want to be ready to act if the rules change. This might entail doing Roth conversions sooner rather than later if allowed by the plan’s rules.
With a QLAC, you can defer taking withdrawals on this money until age 85. This can be a way to grow some of the money in the account and to have a source of guaranteed lifetime income. Once you begin withdrawing from the QLAC, RMDs and taxes would be due on this money.
Before going this route you need to understand any limits on the amount that can be invested in a QLAC. You should also be sure to understand all costs and expenses associated with the QLAC you are considering as well as how your money can be invested.
A QLAC can be a good way to help ensure that you don’t outlive your retirement savings as well as a way to defer a portion of your RMDs and the associated taxes.
It’s all about planning
Any decision as to whether to use any of these tactics to reduce RMDs and the taxes due should be done as part of your overall retirement and financial planning. Reducing or eliminating the taxes due on RMDs is a good thing, but you need to be certain that the benefits of doing this don’t outweigh the costs over time. This is a case where there is no “free lunch.” Be sure the short-term benefits outweigh the overall costs, as we said at the outset there is generally a trade-off involved with using any of these strategies.