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How to make the most of your required minimum distribution

The end of the year is fast approaching and so is the Dec. 31 deadline for seniors who must take the annual "required minimum distribution" from their traditional individual retirement account.

Many workers focus on building tax-deferred savings during their career without thinking much about the tax bite that will come when they start making withdrawals.

However, Uncle Sam requires everyone start taking RMDs from their IRAs and other tax-deferred accounts once they reach age 70½. And that means you start paying income tax on the amount that is withdrawn.

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You do not have to take an RMD from a Roth IRA, but your non-spouse beneficiaries will have to after your death. Spousal beneficiaries have the option to start making annual withdrawals or delay taking any RMD until they reach 70½.

"At first glance, the rules might seem simple," says Denise Appleby, CEO of Appleby Retirement Consulting. "However, there are nuances that should be taken into consideration so that you do not have an RMD shortfall."

What happens if you don't take the appropriate distribution from your retirement accounts by the deadline? You'll have to pay a 50 percent penalty on the difference between the amount you withdrew and the amount you should have withdrawn.

Retirees should be aware: You'll also have to starting taking RMDs at 70½ if you have a 401(k), pensions, 403(b), thrift savings plan (TSP), governmental 457(b) plan or another employer-sponsored plan and are no longer working with the employers that provided the plans.

RMDs must be taken by April 1 of the year after you turn 70½. It's also worth noting that you have to take your second RMD by Dec. 31 of that same year, which would mean taking two RMDs in one year. And you must continue to take your RMDs by Dec. 31 of every year for the rest of your life, or until you've depleted those accounts.

For older workers who are enrolled in an employer-sponsored plan, you may be able to delay your RMDs.

"These RMDs could raise your tax rate, increase your Medicare premiums and cause more of your Social Security benefits to be taxed, up to 85 percent." -Jamie Hopkins, associate director, Retirement Income Program at The American College

"You can roll your IRA into to the 401(k) of your current employer [if allowed] and put off RMDs until you retire," explains certified financial planner Rich Coppa, managing director of Wealth Health.

Although many Americans wish they could put off paying income taxes, Coppa warns savers to "consider the tax bracket you are in when you turn 70½ ."

'It may make sense to take the RMD the year you turn 70½ rather than pushing it off until the following April, when you then would have to take two IRA distributions which can push you into a higher bracket."

"RMDs from your 401(k) or IRA will likely be taxable as ordinary income," warns Professor Jamie Hopkins, associate director of the Retirement Income Program at The American College. "These RMDs could raise your tax rate, increase your Medicare premiums and cause more of your Social Security benefits to be taxed, up to 85 percent."

So you'll want to plan properly, he says.

Although everyone is required to make withdrawals from traditional IRAs and employer-sponsored plans, you may not need the money right away. Consider putting those funds back to work.

Here are a few ways to do just that:

  • Invest in municipal bonds and municipal bond funds. They'll pay income that is free from federal and, in some cases, state and local income taxes.
  • Invest in stocks you intend to hold longer than a year. Sales of appreciated stocks held more than 12 months are taxed at lower long-term capital gains rates.
  • Pick stocks that pay qualified dividends. Qualified dividends are taxed at the same low rates as long-term capital gains, rather than ordinary income rates.

It can get complicated, so it makes sense to talk to a financial advisor to make sure these are the right moves to make the most of your RMDs.