A Tax-Efficient Way to Manage Required Minimum Distributions

A Tax-Efficient Way to Manage Required Minimum Distributions

What is a Required Minimum Distribution (RMD)?

When you enter retirement, your initial portfolio withdrawals will likely be discretionary. Meaning you will be able to decide how much you withdraw from which accounts based on your income needs

This is true until you reach age 72. At this point, the IRS requires you to take minimum distributions (RMDs) from your employer-sponsored retirement plans and traditional IRAs. Failure to take the required minimum distribution could result in a 50 percent penalty on the amount that should have been withdrawn. 

Your annual RMD is based on your age, the value of your accounts on December 31 of the previous year, and your life expectancy factor.

Required Minimum Distribution Formula:

RMD = Prior Year-End Account Balance / Life Expectancy Factor

Required Minimum Distribution Example 1

For example, Joe Smith turned 72 on January 1, 2021, and is married to Jill Smith who is 68. Joe’s traditional IRA was valued at $1,000,000 as of December 31, 2020. Based on the current uniform life tables, Joe’s withdrawal factor is 25.6. Therefore, his required minimum distribution for 2021 is $39,062.50.  

Required Minimum Distribution Example:

RMD: $1,000,000/25.6=$39,062.50.

What is a Qualified Charitable Distribution (QCD)?

Required minimum distributions could create an unwanted tax liability for someone who does not need the income to fund their retirement. This is because the extra taxable income can bump you into a higher tax bracket, increase the taxes on your Social Security benefits or cause you to pay higher Medicare premiums.

For those who are charitably inclined, qualified charitable distributions (QCDs) may be a useful tool to potentially keep your adjusted gross income within the desired range. QCDs provide a tax-efficient way to manage required minimum distributions from a traditional IRA while benefiting a qualified 501(c)(3) charity.

A QCD, allows you to contribute to an eligible public charity and receive a tax benefit, whether you itemize or not. The annual QCD limit is $100,000 per individual given they are 70½ or older. 

This means, when your RMDs begin, you can direct your RMD to charity and exclude the distribution from your taxable income. In addition, you can still give more to charity through a QCD than your RMD amount but cannot exceed the $100,000 annual limit. *

Required Minimum Distribution Example 2

Going back to the earlier example, the Smiths’ had 2020 income as follows: $5,000 interest income, $30,000 dividend income, $60,000 Pension Income; $35,000 of IRA income; and $50,000 annual Social Security benefits (of which only 85 percent, or $42,500, is considered taxable in the formula for modified adjusted gross income) for a total annual income of $180,000.

Their resulting modified adjusted gross income is $172,500, which is under the $176,000 Income-Related Monthly Adjustment Amount (IRMAA) income threshold for joint filers. In 2020, the Smiths’ were able to fund their living expenses without triggering the Medicare surcharges.    

However, in 2021 Joe’s RMD was $39,062.50 while the rest of their income remained constant. This added $4,063 income would push their income above the $176,000 threshold and trigger Medicare Part B and D surcharges in two years.

Using the 2021 figures, this would increase their Part B premium by $59.40 per month, and their Part D premium by $12.30. This would result in a total premium increase of $860.40 per spouse for that year. 

Required Minimum Distribution Example

Qualified Charitable Distribution Example

One potential way to avoid this is by using a QCD. Joe could direct the first $4,063 of his RMD to a qualified 501(c)(3) charity of his choice and use the remaining $35,000 to fund their living expenses. Since the $4,063 was sent to a charity they will be able to exclude that amount from their taxable income.

This would reduce their modified adjusted gross income to $172,500. This would put them below the $176,000 threshold, and they would not be subject to the premium surcharges in two years. **

Qualified Charitable Distribution Example

Qualified charitable distributions can be a tax-efficient way to manage required minimum distributions for those who are charitably minded. Because of their tax benefit, QCDs and RMDs should be carefully coordinated to ensure proper timing. It is reasonable to seek out help from a trusted advisor to aid you with their execution.

*A QCD must be an otherwise taxable distribution from your IRA. You cannot retroactively classify an RMD as a QCD. Also, you cannot deduct a QCD as a charitable contribution on your federal income tax return.

**These hypothetical examples are used for illustrative purposes only. Actual results will vary.

Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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