How to Beat Taxes After 70 1/2

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Here’s a partial solution to the required minimum distribution (RMD) tax trap I talked about last week.

When you turn 70 1/2, the RMD takes control over the minimum amount you can withdraw from your retirement accounts – all of them.

You can no longer sit back and let them all accumulate tax-deferred. You have to take a certain amount out each year, which can create all kinds of tax issues.

But limiting the effects of this forced income source isn’t brain surgery. You can start by using this worksheet provided by the IRS (click here).

The worksheet is a three-step process to calculate how much you have to take out of each retirement account every year. That includes all of your IRAs and any 401(k)s you might have lying around.

If you fail to make the required distribution, the penalties can be very tough. How does 50% of the RMD amount sound?

If you make an honest mistake, what I have been reading tells me the IRS is somewhat lenient with seniors – senior moments and all. But if you know anything about the IRS, you know it isn’t stupid. You will rarely get the benefit of the doubt. So make sure you make your distributions on time from all of your accounts.

But the potential costs of the RMDs don’t stop with neglecting to withdraw as required.

Let’s suppose you turned 70 1/2 last year, you’ve done well and you have $400,000 in retirement accounts. If you use the worksheet in the link above, you’ll see that you have to take out a minimum of almost $15,500 this year.

Surprise! That $15,500 goes right to the income line on your tax form, and that bumps many into a higher tax bracket. A higher bracket means a higher tax bill, and most people don’t see it coming.

Luckily, there is a two-step way to meet your RMD and reduce the impact it will have on your taxes going forward, and it’s pretty simple to do.

First, you don’t have to take cash distributions to meet the RMD. You can transfer securities of the same value.

Second, you can take the RMD at any time during the year (as long as you start within one year of hitting 70 1/2), not just at tax time.

The key is to wait for a down period in the market when your assets have dipped in value so you can move more shares out of your accounts than you could if you had done it during an up period. Remember, it’s the total dollar value the IRS is interested in, not the number of shares or bonds moved.

Let’s suppose you got hit with the full 20% drop in stocks last December and took advantage of this strategy. You would have transferred your full RMD amount into a taxable account using assets, not cash. You would have been able to move 20% more shares out than you would have in late September, when the market was higher.

The assumption here is that your stocks will rebound in value. They’ve already recovered about 50% of that drop, so you would have legally beat the government out of 20% of the taxes due at a higher market value by moving 20% more shares than if you had transferred cash.

To be clear, this wouldn’t lower your nominal tax bill this year. If you had to distribute $15,500, as in our example, you would still owe taxes on that amount. But going forward, you would have fewer shares left in your retirement account that would need to be distributed.

That’s where you can really save some big tax dollars. If you do this when the market is down, which is more often than not, you can get more and more shares out each year.

This is the only way I know for the average guy to get a break on these required distributions. And it’s perfectly legal.

Of course, to make this strategy work, you will have to kick any panic-selling habits and learn to see all sell-offs not just as buying opportunities but as tax reduction opportunities too.

Turn your RMD and bad market news into lower tax bills and better buying opportunities.

Good investing,

Steve