What To Do With An RMD You Don’t Need
This may seem like an unusual year to be talking about required minimum distributions (RMDs) since Congress has temporarily eliminated them in 2020 due to the COVID-19 pandemic. But they haven’t gone away. After all, the government does need to collect the taxes they allowed you to defer throughout your working years. If you’re a retired senior in your 70s you are undoubtedly familiar with the requirements for taking minimum distributions from your IRA, 401(k), 403(b), or other retirement accounts. Basically after a certain age (72 if you were born after June 30th, 1949, otherwise 70 ½) you have to withdraw and pay ordinary income taxes on a certain percentage of your retirement account savings every year. Many retirees use that money for living expenses. If you are fortunate enough to have enough other sources of income, though, you’d probably prefer to avoid having to take the RMDs and pay the taxes. While you can’t do that directly, there are a couple of tax-beneficial ways you can address them when they’re not actually needed for expenses.
- Make a qualified charitable contribution (QCD). Up to $100K of your RMD can be contributed to charity and the tax deduction for the charitable contribution will offset any tax owed on the RMD. See https://www.cognizantwealth.com/2019/01/18/how-still-to-get-charitable-tax-deductions/.
- Create a Qualified Longevity Annuity Contract (QLAC). A QLAC is a deferred income annuity inside your IRA that pays you monthly income starting 10 or 20 years in the future. It’s a way to both reduce the size of your RMDs (since the amount placed into the QLAC is removed from your IRA balance) plus get a guaranteed stream of income regardless of how long you live. See https://www.cognizantwealth.com/2015/09/14/how-to-delay-the-irs-from-taxing-your-savings/. (Note that the maximum amount has been raised to $135K for 2020 and isn’t limited just to the amount you owe for an RMD).
- Pay for Long-Term Care insurance (LTCI) premiums. While the RMD itself will still be taxable, up to $10,860 of premiums paid for LTCI (for a married couple over age 70) will be deductible in 2020 to the extent that, in combination with your other medical expenses, they exceed 7.5% of your AGI. So by using the RMD to pay for LTCI (or for any of your medical expenses), the tax deduction for the amount above 7.5% of your AGI could offset the taxes paid for the RMD. However, you do need to itemize deductions and have enough medical expenses in order to make this work.
- Do a Roth conversion (2020 only). Ordinarily RMDs cannot be used for Roth conversions. But if your retirement plan in 2020 included taking the distribution and paying the taxes anyway, you might consider withdrawing the equivalent amount and moving it to a Roth (that’s what a Roth conversion is). Although you’ll incur taxes on the transfer, the money you convert will grow tax-free for the rest of your life. Having tax-free money available in a Roth account should your spouse predecease you in the future (when your tax rate doubles as you become a single taxpayer) can be fortuitous. Plus you’ll reduce the size of your IRA which will help reduce your future RMDs.
All these choices are available only in IRAs. What if the only retirement account you have is a 401(k)? No problem. You can easily create an IRA and roll over the assets in the 401(k) into the IRA. There are differences, however, between IRAs and 401(k)s. I recommend you consult with your CFP to understand the plusses and minuses of a rollover before initiating one.
If none of the choices above appeals to you, then by default you can deposit the RMD into a taxable account and reinvest it.