If you want to minimize your tax burden in retirement you need to know about the dreaded RMDs (required minimum distributions). Starting at age 72 RMDs begin to siphon off whatever you have saved in IRAs, 401(k) and other kinds of tax deferred accounts. They can be avoided, but not without giving up current day tax benefits associated with IRAs and 401(k)s. 

What Are Required Minimum Distributions?

If you own a tax-deferred retirement account, federal law requires all account holders to take required minimum distributions or RMDs once they reach age 72. These withdrawals are considered taxable income. 

RMDs apply to tax deferred retirement accounts including traditional IRAs, company-sponsored retirement plans (401(k), 403(b), 457), and self-employment retirement accounts (SEP IRA, SIMPLE, etc).

The good news is Roth accounts are excluded from RMDs. When it comes to inheriting a Roth account the rules are different and that is a totally separate discussion not covered here.

With your IRA / 401(k) Uncle Sam gave you a tax break during your wealth building years. This benefit can be $10,000 - $20,000 per year for high income earners. Starting at age 72 you will be forced to withdraw a portion of that money and be taxed on it accordingly. If you saved a substantial nest egg your required minimum distribution can be quite large. 

RMDs can be enough to bump you into a tax bracket you did not expect. That in turn eats into your social security and pension benefits.

How to Calculate RMDs

Calculating your RMD is fairly simple. The IRS has a worksheet that walks you through the calculation process. 

All you need to do is find your distribution factor (based on your age). Then divide your account balance by your distribution factor.

Here are some examples:

The older you are, the higher the RMDs become.

Here is a table that shows the required minimum distribution as a percentage of your combined retirement accounts by age:

* Traditional IRA, 401(k), 403(b), 457, SEP IRA, SIMPLE, but not Roth accounts.

The Catch with Tax-Deferred Retirement Accounts

Required minimum distributions start at 72 and GROW as you age. There are two certainties in life: death and taxes. Boy is that right in the face of every 100 year old in America.  Seems a bit unfair doesn't it? Congress did not “respect their elders” when they created these rules. Then again, a deal is a deal.

Unfortunately RMDs are something most young people are not aware of or ignore since it is so far out in the future. 

For my part, if I live to be 100, first, I hope I’m not in diapers and I know what day it is. Second, I get to watch the IRS legally claim a larger and larger chunk of whatever I have left.
 

Are there ways around Required Minimum Distributions?

To avoid RMDs, the short answer is don’t put money into an IRA, 401(k) or other account subject to them. One good alternative is a Roth account - where you pay taxes up front, but the balance grows tax free and withdrawals are tax free, and no RMDs.

The long answer starts with a question:

Have you ever heard the saying, “don’t put all your eggs in one basket”? Well, this is spot on when it comes to investing for retirement. Many retirees contribute the majority of their retirement savings to one retirement account. Nobody is forcing you to use just one account.

Automating contributions to IRA / 401(k) and Roth accounts would be one solution. That way you can take advantage of employer matching, but not paint yourself into a corner with RMDs. Some employer retirement plans offer a Roth 401(k) option which makes it easy.

The next question is, how much do RMDs bother you? Personally I dislike paying taxes, but between “current me” and “future me” I’m not sure who to favor the most. In retirement I want to max out my social security, so I want to minimize RMDs. At the same time “current me” really likes the tax benefits associated with IRAs and 401(k). So I have to strike a balance. Generally I like flexibility, so in that regarding doing a little of both makes sense.

Some additional questions to ask yourself:

• How much do I want in retirement? We’ve talked about how much is enough but anywhere from $300,000 - $2,000,000 is worth thinking of.
• Can I get to my goal using a combination of Roth and non-Roth style accounts? What relative percentages make sense? 50/50 split, or something else?
• Will taxes go up or down between now and when I’m in retirement?
• How can I get the most out of social security?
• Have I maxed out take home pay by meeting the employer match portion of my retirement plan at work?
• Rather than funding retirement, does it make sense to pay down debt, build a business, or go for experiences and personal enrichment?
   

The Bottom Line

While pre-retirees work hard and save money, they often forget to factor in their tax burden in retirement. A huge piece of the retirement planning process has to do with managing taxes, particularly how RMDs factor in.

RMDs can be a big hit to your retirement savings. If with proper planning and consultation from a financial planner you can avoid putting your entire nest into accounts that are subject to RMDs. However the drawback is the wonderful tax perks that come with funding those accounts go away.

Figuring out which one works best for you may be a bit of a challenge if you don’t have extensive financial experience and knowledge. That’s why it may be wise to partner with a financial professional who can take an unbiased approach to your portfolio. You need a financial professional who can evaluate all of the pieces of your financial puzzle and help you determine the best way to fit them together. Working with someone who can see the entire financial picture and put your hard-earned money to good use will help you create the ultimate tax strategy.