Maximizing Rmd Funds: Strategies For Smart Investing

Required minimum distributions (RMDs) are mandatory annual withdrawals from certain retirement accounts, such as traditional IRAs and 401(k)s, that individuals must take once they reach a certain age. The age at which RMDs become mandatory varies depending on the birth year of the account holder, but it is typically between 72 and 75 years old. Failure to take the RMD can result in significant penalties, such as a 25% excise tax on the amount not withdrawn.

So, what is the best way to invest these RMD funds? Here are some options:

- Reinvest in a taxable investment account or brokerage account.

- Contribute to a 529 college savings plan for a family member.

- Donate to a qualified charitable distribution (QCD).

- Pay off debt or high-interest loans.

- Invest in stocks, bonds, exchange-traded funds (ETFs), or mutual funds.

- Roll over into a Roth IRA.

- Use for living expenses or big-ticket items.

Reinvesting in a taxable account

If you don't need your RMD for day-to-day living expenses, you can reinvest it in a taxable brokerage account. You can then reinvest according to a strategy that fits your needs.

You can also reinvest your RMD in a taxable investment account, but you can’t invest it in most retirement accounts. You can also redirect RMDs toward other tax-advantaged uses, such as 529 education plans and qualified charities.

A shares-in-kind distribution may also be an option to consider. If you would like to give someone's education a head start, you could use the money you take for your RMD to fund a 529 college savings account.

You might be able to contribute your RMD to a Roth IRA as long as you have earned income in an amount equal to or greater than the RMD amount you contribute to the Roth IRA. However, the RMD amount you must take is still considered taxable income in the year you take it.

If you have multiple IRAs because you want to maintain separate IRAs for different beneficiaries, consider equalizing the balances, which may have changed as a result of withdrawals, contributions, fees, and asset performance. If you have designated a different individual as the beneficiary for each of your three IRAs, for instance, and you want to leave them all the same amount, you may withdraw your RMD amount from the IRA with the highest balance.

Alternatively, you may transfer amounts among the IRAs to equalize the balances and withdraw the applicable RMD amount from each IRA.

Using RMDs for living expenses

Many retirees use RMDs to cover routine expenses. Using the funds you worked so hard to save for your retirement lifestyle is a worthy goal, especially if you don't expect to be in a higher tax bracket during retirement since RMDs are taxed as ordinary income.

Think about how RMDs factor into your retirement budget. For example:

• Are you working part-time?
• Do you have a pension partially funding your retirement?
• Are you receiving Social Security benefits?

A retirement income calculator can help you inventory your retirement income sources. It often makes sense to have a budget in retirement. Going through the budgeting process can help you estimate living expenses, manage your cash flow, and determine if you'll need to use your RMDs to fund your retirement lifestyle.

If you plan to use RMDs to pay for current living expenses, consider using a cash management account to pay your expenses.

Important considerations

• RMDs are determined each year by dividing the account's prior year-end value by a life-expectancy factor set by the IRS.
• The deadline to take your first RMD is normally April 1 of the year after you turn 73, and December 31 each following year.
• The IRS penalty for not taking an RMD, or for taking less than the required amount, is 25% of the amount not taken on time.
• Many people choose to have taxes withheld from their RMDs as it is counted as ordinary income.

Completing a Roth IRA conversion

A Roth IRA conversion can be a great way to take advantage of lower tax rates and establish tax-free retirement. Here are the steps to complete a Roth IRA conversion:

Step 1: Open a Roth IRA Account

You will need to open a Roth IRA account at a financial institution. If you already have a Roth IRA account, you can use that account to hold the converted funds.

Step 2: Contact Your Plan Administrators

Reach out to both the new and old financial institutions to understand what is required to make the conversion to the new account. This step may be easier if you are simply opening a new account at the same institution.

Step 3: Submit the Required Paperwork

Once you know what paperwork needs to be filed, submit it to the relevant institutions. You will need to specify which assets are being converted.

Step 4: Notify the IRS

When it is time to file your taxes for the year in which you made the conversion, submit Form 8606 to notify the IRS that you have converted an account to a Roth IRA.

Things to Keep in Mind:

• Any money moved from a traditional account to a Roth IRA will be treated as ordinary income and taxed accordingly.
• Converting a traditional IRA or 401(k) to a Roth IRA will be taxed and penalised if withdrawals are taken within five years of the conversion and before the age of 59 1/2.
• If you make multiple Roth conversions, each is subject to its own five-year rule.
• A Roth IRA conversion may be more suitable if you expect to be in the same or a higher tax bracket during retirement.
• You can pay the conversion taxes without using the retirement funds themselves.
• You may not need the funds for retirement and may want to transfer them to your beneficiaries.

Paying college expenses

Paying for college expenses is one of the ways to use your RMDs effectively. Here is some detailed information on how to do that:

529 College Savings Account

If you don't need your RMD for retirement expenses, you can use it to fund a tax-advantaged college savings account. The SECURE Act 2.0 allows you to roll over a lifetime cap of $35,000 from a 529 plan to a Roth IRA in the name of the student beneficiary starting in 2024. However, the 529 account must be at least 15 years old, and the owner needs to have earned income. Keep in mind that rollovers will be subject to the annual Roth IRA contribution limit of $6,500 in 2023 or $7,000 in 2024.

529 Education Savings Plan

You can also use your RMD to contribute to a 529 education savings plan. This way, your RMD can pay for tuition or other college expenses for a grandchild or another student, such as an adult who wants to pursue an advanced degree. A 529 plan allows your investment to grow tax-deferred, and withdrawals for qualifying educational expenses are tax-free.

To use your RMD to fund a 529 plan, take the distribution as you normally would and then establish an account naming the student as the beneficiary. You may be able to automate RMDs and 529 contributions so that every time your RMD is paid out, a contribution goes into the 529 account.

Other Options

If you are still working and don't need the RMD funds for college expenses, you can reinvest them in a taxable investment account or a mutual fund. You could also consider a Roth IRA conversion, but keep in mind that this is a taxable event, and the tax bill can be significant. Consult a tax professional to determine if this is the right move for you.

Donating to charity

QCDs are a very tax-effective way to support a cause. Individuals over 70 1/2 can donate up to $100,000 (adjusted for inflation yearly) from a traditional or inherited traditional IRA tax-free. This allows the donor to exclude the amount from their taxable income. For example, RMDs can push retirees into a higher tax bracket as distributions are ordinary taxable income. Additionally, RMDs can trigger the 3.8% Medicare surtax and cause Social Security benefits to become taxable.

If you are thinking of donating your RMDs to charity, you should be aware of the following:

• The retirement account owner must be age 70 1/2 or older.
• The annual QCD limit is $100,000 per account owner.
• Donations must go directly from your IRA to the qualified public charity.
• Most types of IRAs qualify: traditional IRA, rollover IRA, inherited IRA, and inactive SEP and SIMPLE IRAs.
• QCDs only apply to taxable distributions.
• You will need to report QCDs on your tax return.

Overall, donating your RMDs to charity can be a tax-efficient way to support causes that are important to you while also reducing your tax burden.

Frequently asked questions