How To Cut Taxes On Your IRA Withdrawals

Tax deferred retirement accounts shield income from tax as long as the money stays put. But even if you don't need the money, you must take out at least a certain amount each year after you reach age 70 1/2.

Required minimum distributions (RMDs) apply to most plans. That includes traditional IRAs, SIMPLE IRAs and SEP IRAs. If you still have money in a 401(k) or 403(b) or 457 plan, you usually must take RMDs after age 70 1/2.

RMDs can be painful. But you can ease the bite by advance planning.

IRS tables set the minimum you must withdraw each year. "As you grow older, RMDs become a larger portion of your retirement account," said Ed Slott, an IRA expert in Rockville Centre, N.Y.

At age 75, for example, most people have a life expectancy of 22.9 years, for this purpose. So the RMD is about 4.4% of their IRA balance the previous Dec. 31.

By age 90, the RMD is usually around 8.8% of the IRA balance.

Withdrawals from retirement accounts are generally taxable. You pay income tax, not capital gains tax, and taxable withdrawals boost your adjusted gross income.

A higher AGI, in turn, can cost you tax deductions and credits. in full. You'll owe a 50% penalty on any shortfall. If your RMD is $30,000 this year and you take only $8,000, you'll owe an $11,000 penalty.

One tactic for reducing future RMDs is to convert your traditional IRA to a Roth IRA. Owners of Roth IRAs never have to take RMDs, no matter how old they are.

And all Roth IRA withdrawals are tax-free, after five years from the conversion and after age 59 1/2.

You'll owe income tax on a Roth IRA conversion. But you can do partial conversions, year after year, to dilute the pain. A partial conversion can generate a smaller tax bill. And it can keep you out of a higher tax bracket.

Test-drive any conversion with a Web calculator to make sure you come out ahead.

Tax Cut Tactic

Suppose a hypothetical Ron and Janice Brown, both age 45, expect their 2011 taxable income to be $100,000. They'll be in the 25% tax bracket, which goes up to $139,500 this year, for couples filing jointly.

The Browns could convert up to $39,500 of their traditional IRAs to Roth IRAs by year-end. They'll owe 25% on the conversion. But that could be a good deal if tax rates are higher in the future.

And they'll reduce future RMDs. With a series of partial conversions, the Browns could convert most or all of their traditional IRAs to Roth IRAs before age 70 1/2.

Then their RMDs will be small or zero. A similar opening arises after age 59 1/2. Then the 10% early withdrawal penalty won't apply.

So you could take some money from your traditional IRA while you're in your 60s. You could withdraw just enough to stay within a tax bracket. And withdrawals will help prevent outsize RMDs later.

Of course, if you put that money in a non-tax-deferred account, it will be subject to tax on any income and capital gains. But usually cap gains are taxed less and are more controllable.

Say a hypothetical Jim and Kate Martin are retired, both age 62. They expect taxable income (after deductions) to be $50,000 this year. They could take up to $19,000 from their traditional IRAs this year. They'd still be in the 15% bracket, which goes up to $69,000 of taxable income on joint returns.

By taking some lower taxed IRA money now, the Martins can reduce future RMDs. That could help them avoid taking higher-taxed IRA money later.

And by taking $19,000 from their IRAs this year, the Martins might afford to defer the start of their Social Security benefits. From age 62 to 70, every year that you defer benefits makes your checks about 8% larger, once you start. Do what-if calculations to verify that this tactic works in your situation.

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