What to Do With RMDs

By Justin Pritchard, CFP®

When you’re required to take distributions from your pre-tax accounts, you might not need the money for spending right away. So, what do you do?

This is important to know whether you’re taking an unneeded required minimum distribution (RMD) this year or you’re planning for a retirement that’s several years away. The sooner you put strategies in place, the more likely it is for things to go the way you want.

RMDs can be anything from a minor task—a box you need to check every year—to a significant tax problem.

Continue reading below, or watch this video with similar information:

RMDs Can Be a Big Deal

The IRS does not allow you to keep money in pre-tax retirement accounts forever. Once you reach a certain age, you must withdraw funds from those accounts, which generally creates taxable income.

That can be problematic in some cases. Additional income on your tax return may complicate your life and affect you in surprising—but potentially avoidable—ways.

  • Tax brackets: If you take large RMDs, the extra income might put you into high tax brackets. Any income you take in those brackets (such as your entire RMD) might be heavily taxed, leaving you with less to spend.
  • Healthcare costs: Your Medicare premiums may be affected by a high income. If you exceed certain levels, you’ll need to pay higher premiums. There’s a delay, but you still have to pay extra.
  • Social Security taxation: When you have income from sources like IRA distributions, your Social Security retirement benefits may be taxable. With more income from IRAs, more of your Social Security is included in your taxable income. As a result, Social Security can go from tax-free income to partially (or mostly) taxed.
  • Other issues: The higher your income, the harder it is to qualify for credits, deductions, and various programs.

Fortunately, there may be ways to avoid the worst problems

In no particular order, here are some ways to use funds from an RMD that you don’t really need. We won’t cover every option here, but these are some of the most popular solutions.

Donate the Money With a QCD

There are several reasons to consider giving your RMD to a tax-qualified charity, starting with the impact you can make for a cause you value. When done properly, you get a tax benefit while maximizing the amount that goes toward the nonprofit’s operations.

A qualified charitable distribution (QCD) happens when you send money directly from your IRA to a tax-qualified charitable organization. But it’s critical that the funds move directly from your retirement account and do not go to you (or your bank account) first.

If you complete a QCD, the RMD is not included in your income. As a result, the transaction doesn’t increase your gross income. That way, you might dodge some of the problems highlighted above.

The real benefit comes from giving pre-tax money to a charity. If you go another route, you’d need to withdraw the funds from your IRA, pay income tax on the withdrawal, and send the remaining funds to your favorite charity. But with the QCD, you skip the part about paying taxes so there’s more to give.

What if you give to charity without using a QCD? You might get a deduction if you pay yourself out of your IRA and subsequently donate money to charity. But deductions on those cash contributions may be limited. With a QCD, on the other hand, the entire amount of your donation is excluded from your income.

You must meet specific requirements to properly execute a QCD, so be sure to research the strategy carefully. You can donate up to $100,000 (indexed for inflation), which should be more than enough for most of you.

One quirk to keep in mind is a mismatch in ages when it comes to RMDs and QCDs.

  • You can do QCDs at age 70.5 or later under current law.
  • Your RMD might begin at age 73 or 75.

Finally, remember that you can use donor-advised funds (DAFs) to simplify your charitable giving. Instead of arranging multiple QCDs, you can use a DAF to manage giving on your behalf.

Reinvest Your RMD

You can reinvest your RMD for long-term growth if you don’t need the money right now. To do so, you might use a taxable brokerage account and buy investments like a diversified portfolio of mutual funds or ETFs. You can use the same investment risk level or choose a different level of risk, if appropriate.

In your taxable account, the assets will gain and lose value with the markets—similar to your retirement account. But any income will be reported on your taxes each year. So, for example, dividends, interest, and capital gains in those accounts could add to your income tax liability. That’s not a reason to avoid investing, but it’s important to know. You might choose to favor tax-efficient investments in your taxable account.

Take an RMD In-Kind?

Most people sell assets in their IRA and distribute cash to take RMDs. There’s nothing wrong with that practice. But you can also transfer shares of your investments from your IRA to a taxable brokerage account to satisfy the RMD. For example, you might select shares of a mutual fund and shift those shares to your taxable account.

An in-kind RMD can be appealing for several reasons:

  • You stay invested and keep your portfolio in balance. If the markets move during the process, you won’t be on the sidelines. Of course, that only works in your favor if markets go up, and it’s a drawback when markets fall.
  • It’s easy. If you want to stay invested, you won’t need to enter a sell order, distribute cash, wait for the transfer, and enter a buy order in your taxable account. You can move shares and be done with it.
  • You keep investments that might not be available for purchase in your taxable account.

A challenge with in-kind RMDs can be ensuring that you meet the minimum requirement. Since the market value of your investments can change every day, you can’t be certain how much you’ll distribute. So, if the market falls when your custodian completes the process, you might move less than you wanted. In that case, you’ll need to make up the difference.

Can You Reinvest the RMD in Your Roth?

Since the money has been taxed, a Roth IRA would seem like an excellent place for those funds.

Unfortunately, you cannot directly reinvest an RMD in a Roth IRA. The funds must move from a pre-tax retirement account to a taxable account. However, if you have earned income for the year, you could potentially make a new Roth IRA contribution, effectively reinvesting the RMD into your Roth.

If you don’t have earned income that’s eligible for an IRA contribution, you would not be able to contribute to Roth. That’s the case for many people who are taking RMD—they’re already retired.

What about converting your RMD to Roth? Unfortunately, it’s not allowed. The IRS wants that money to move out of tax-favored accounts and into fully taxable accounts.

Put Your RMD in the Bank

When funds come out of a pre-tax account, you’re free to use that money for anything you want. You can just transfer your RMD to your checking or savings account and spend on the things you want and need (assuming you can afford everything, of course).

You might use the money for any of the following:

  • Basic household needs: Blend it in with the rest of your budget.
  • Future spending needs: Put the money in a savings account. You’ll likely have healthcare-related needs and other expenses in the future. If you want to keep the money safe, a bank or credit union may be appropriate.
  • Give it away: If you don’t need the money, you might give some to your loved ones (but for giving to a tax-qualified charity, there’s a better strategy).
  • Pay taxes: If you’re doing Roth conversions (which gets less likely after your RMDs begin), you may have extra liquid funds to put toward the tax bill.

Pay Some Taxes

If you’re getting RMDs and income from other sources, there’s a decent chance that you’ll need to pay income taxes. Your RMD can be a source of funds for those taxes.

As a retiree—instead of a wage-earner who pays taxes with every paycheck—you might need to make estimated tax payments. For many, that happens four times each year through quarterly payments to the IRS.

But you can also have taxes withheld from your RMD. For example, you might choose to have 10% or even 100% of your RMD go to the IRS instead of receiving it.

Why would you do that? Maybe you need to pay taxes and you don’t need the cash flow.

You’re required to pay at least a “safe harbor” amount to avoid underpayment penalties. To do so, you can send the IRS at least 90% what you owe for the year, or 100% of the previous year’s tax liability (110% for those with a high income).

When you have taxes withheld from your RMD, you can potentially simplify life and make your required tax payments in one chunk. You could even wait until late in the year to do this, enabling you to figure out what your earnings look like for the year.

Ultimately, withholding from your RMD can potentially help you avoid underpayment penalties. Those withholding payments are considered to be received throughout the year, which can be helpful if you missed some estimated tax payments earlier in the year.

Work with your tax expert to evaluate if paying taxes with your RMD makes sense.

Manage Your RMDs

If you’re in the pre-RMD phase of life, you may be able to influence how large your RMDs are.

The larger your pre-tax retirement accounts, the bigger your RMDs. Again, large RMDs can cause problems when it comes to taxation and healthcare expenses, so you may want to do some planning sooner than later.

There are a few ways to reduce your future RMDs when you have time before RMDs begin. Among other options, you could consider the following:

  • Roth conversions: You can convert pre-tax assets to Roth by choosing to pay income taxes early. Doing so might smooth out the flow of money from pre-tax accounts, potentially avoiding a large jump when RMDs start. You can do Roth conversions over time, spreading the tax burden over multiple years.
  • Spend from pre-tax accounts: If you need to spend the money instead of shifting it around, you can simply draw from pre-tax retirement accounts and leave your taxable holdings alone. You’ll chip away at the size of your pre-tax assets, ultimately reducing the size of future RMDs. That might fit well with a Social Security bridging strategy.
  • Charitable contributions: Remember that you can use QCDs to get funds out of pre-tax IRAs beginning at age 70.5 under current law—before your RMDs begin. That mismatch might not last forever.

If you pursue any of those strategies, be mindful of how they affect your income. You might simply pull future tax problems into the present. For instance, if you convert a significant amount, you could impact your Medicare premiums or find yourself in an especially high tax bracket, so plan carefully.

As you decide how much to convert or withdraw, keep an eye on important levels (such as Medicare/IRMAA thresholds, tax brackets, and Social Security taxation, among others). With careful planning, you can often select an amount that keeps you below key thresholds that could cause you to spend extra money.