Timing Your RMDs: A Tax-Smart Approach

Withdrawing your annual required minimum distributions (RMDs) from qualified retirement plans and IRAs at the beginning of the distribution calendar year, rather than at the end, can offer advantages, particularly in terms of after-tax return on investment.

RMDs are mandatory for qualified defined contribution retirement plans under Internal Revenue Code Section 401(a)(9) and for Individual Retirement Plans under Internal Revenue Code Section 408 (excluding Roth IRAs). These distributions typically begin after a plan participant or IRA owner reaches a certain age. The core question is whether the timing of these withdrawals can impact your overall financial outcome.

The advantage of early withdrawal stems from how investment gains are taxed. While your retirement portfolio likely generates both income and capital gains, all distributions from these accounts are taxed as ordinary income, even the portion attributable to capital gains realized within the account. If you take your RMD at the beginning of the year, any capital gains realized on the distributed funds after they've been withdrawn will not be classified as ordinary income. Instead, these gains will be taxed as capital gains only when you sell the underlying assets. Furthermore, if you hold onto these assets until death, they will receive a "step-up in basis," meaning your heirs will inherit them at their fair market value at the time of your death, potentially reducing their capital gains tax liability.

For example, imagine you have an RMD of $10,000. If you withdraw it on January 1st and invest that $10,000 outside your retirement account, and it grows to $11,000 by year-end, the $1,000 gain will be treated as a capital gain when you sell the investment, not ordinary income. If you had kept that $10,000 in your retirement account until December 31st and it grew to $11,000, the entire $11,000 distribution would be taxed as ordinary income.

However, this strategy is less beneficial if your investment focus is primarily on holdings that generate ordinary income, such as bonds or certain dividend-paying stocks. In such cases, deferring your RMD until the end of the year might be more advantageous, as the gains would likely already be classified as ordinary income regardless of withdrawal timing.

Want to explore strategies for optimizing your retirement plan and other tax-free income opportunities? Contact me to learn more!

barry.boscoe@brightonadvisory.com

Office: 818-342-9950

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