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You may think that retirement means a lower tax bill because you’re no longer working. For many retirees, it doesn’t always work out that way.
A big reason is the required minimum distribution or RMD. Starting at age 73, most retirees must withdraw money from tax-deferred accounts such as traditional IRAs and 401(k) plans. Those withdrawals are taxed as ordinary income and could push retirees into higher tax brackets, increasing how much they are taxed on their Social Security and increasing Medicare premiums.
“Step one” is reducing how much of your RMD counts as taxable income. The right approach depends on where you are in retirement.
Before age 73, Roth conversions can reduce future taxes
Before RMDs begin, a Roth conversion can give you more control over how your retirement income is taxed.
A Roth conversion moves money from a traditional IRA to a Roth IRA. You’ll pay taxes on the amount converted now, but future withdrawals from the Roth are tax-free, and the account is not subject to RMDs for the original owner.
In the early years of retirement, many people are in a lower tax bracket. Converting parts of a traditional IRA during that time can reduce the balance that will later be subject to required withdrawals.
“The most effective step retirees can take to reduce the tax burden on required minimum distributions is to begin making Roth conversions before RMDs begin,” said Steve Sexton, CEO of Roth. Sexton Advisory Group.
After age 73, QCDs can cut your tax bill
Once RMDs begin, one way to reduce your tax bill is through qualified charitable distributions, or QCDs.
A QCD lets you send money directly from your IRA to a qualified charity. That amount still counts toward your required withdrawal, but it doesn’t add to your taxable income. This matters beyond just income tax. Keeping that income off your return can also affect how much your Social Security is taxed and whether your Medicare premiums increase.
This works best for retirees who don’t need their full RMDs to cover living expenses and who are already willing to donate.
“QCDs count toward your RMDs but are not taxed as income,” said enrolled agent and founder Morris Armstrong. Morris Armstrong EA LLC.
For example, if you need to withdraw $40,000, but only need $30,000 to live on, you can send that extra $10,000 directly to a charity through QCD. That money was coming out of your account somehow. The difference is whether it goes to a cause you care about or to the IRS in the form of taxes.
Note that QCDs can only be created from IRAs, not 401(k) accounts.
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Reducing taxes in retirement doesn’t have to mean finding another deduction. The Roth conversion reduces the balance that generates future RMDs. Once QCD starts, you keep that income away from your return. Both lead to a smaller number on line 15 of your 1040.