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Taking RMDs Into Your Own Hands

IRS rules on required minimum distributions (RMDs) are aimed at people who can afford to pile up savings in tax--favored retirement accounts without ever again having to take out most of that money. In most cases, however, you eventually have to start taking annual RMDs whether you want to or not. But moves you make at year--end can help reduce the tax damage.

Although savings in employer--sponsored retirement plans such as 401(k)s, as well as in traditional IRAs, can grow without being eroded by current taxes, eventually the money must come out. RMDs have to begin by April 1 of the year after the year in which you turn 70½. (Roth IRAs are exempt from RMDs.) Then you must take an RMD by December 31 every year. Those withdrawals generally are taxed at ordinary income tax rates.

If you're still working full--time at a company you don't own, you may be able to postpone withdrawals from that company's plan until retirement. But this exception doesn't apply to IRAs.

The amount of the RMD is based on life expectancy tables and the value of your accounts on the last day of the previous tax year. Suppose you're 75 and the value of all your IRAs on December 31 of last year was $500,000. If your spouse is the sole beneficiary and he or she isn't at least 10 years younger than you are, the withdrawal factor under the appropriate table is 22.9. With an online calculator, you can determine that your RMD for the current tax year is $21,834.

If you have multiple IRAs, you can take the money from any one of them or from several in whatever proportions you choose. But the penalty for failing to take the full RMD is severe—equal to 50% of the amount that should have been withdrawn (or the difference between the required amount and any lesser amount you did withdraw). For instance, if you failed to make any withdrawal in the example above, the penalty would be $10,917, plus regular income tax.

Finally, taking an RMD can trigger other tax complications, including liability under the 3.8% "net investment income" (NII) tax. Although RMDs don't count as NII, they do increase your overall taxable income—and that, in turn, can make you subject to the NII tax.

One way to begin reducing your exposure to RMDs is to convert funds in traditional IRAs to a Roth IRA. Because Roth IRAs are exempt from RMD rules, you'll have more protection for the future, even though you'll owe tax on the conversion for the year in which it occurs. Another potential strategy is to transfer funds to a life insurance trust that isn't subject to the RMD rules. Just keep in mind that such arrangements generally require professional assistance.

The main point is that you don't have to sit back and accept dire tax consequences. Some astute year--end planning can give you more room to maneuver.