Some people think about required minimum distributions (RMDs) as a rite of passage. Before the age of 70 1/2, these withdrawals from qualified tax-deferred retirement accounts are entirely optional – but once you pass that age, they are required by law. IRAs, SEP-IRAs, Simple IRAs, 401(k)s, and other types of employer-sponsored retirement plans are considered qualified tax-deferred accounts.

When it comes to making withdrawals from these types of accounts, there are a few rules to keep in mind. First and foremost, any withdrawals – at any age – will be taxed as regular income.

In addition:

• The optional withdrawals you make before the age 59 1/2 might come with a 10% federal penalty fee, in addition to a possible state fee. There are a few potential exemptions to this penalty fee, such as educational expenses or a first-time home purchase.
• You can make optional withdrawals from tax-deferred retirement accounts once you reach age 59 1/2, minus restrictions or fees.  
• As mentioned above, RMDs kick in at 70 1/2. If you fail to make these mandatory withdrawals, you’ll have to pay an unpleasant 50% penalty fee on the amount you were supposed to withdraw.

RMDs are generally a percentage of the previous year-end balance. And, keep in mind, once the distribution is taken, it cannot remain in a tax-deferred retirement account.

Some people choose to use their RMDs to help cover living costs, bills, and other necessities. But if you don’t need this extra income to cover the basics, you may want to consider these other smart uses for your RMDs.

Boost Inherited Assets with the Stepped-Up Cost Basis

Have assets you’re passing on as inheritance? These (non-qualified) accounts could benefit from the additional investment. The stepped-up value is the asset’s market value at the time the benefactor (you) passes away. Having a higher stepped-up basis can reduce the beneficiary’s capital gain income when he or she eventually sells the inherited asset.

Allocate RMDs Toward Life Insurance

You can also put RMDs toward life insurance premiums. Doing so will immediately increase the inheritance your heirs will receive. While life insurance plans have contribution limits based on age, health rating, and face amount, you can find some peace-of-mind knowing your loved ones can benefit from the added, tax-free money. In addition, most life insurance plans offer tax-free loans and can provide supplemental income during retirement.

Give the Gift of Higher Education

Some individuals may choose to contribute to education expenses for grandchildren or other college-aged loved ones. If this is the right choice for your circumstances, investigate 529 college savings plans that make it easy to “gift” funds. Further, your contributions could be state tax deductible.

Donate to a Cause You Care About

Others choose to use RMDs to donate to charity. Those who are 70 1/2 or older with IRAs can transfer up to $100,000 to an eligible charity via a Qualified Charitable Distribution (QCD). Conveniently, this amount can replace your regular RMD and may be excluded from taxable income. Other types of retirement accounts may not be eligible for QCDs, but donating to charity is still a fulfilling way to use RMDs.

Make the Most of Your Retirement

Some investors see retirement as the perfect time to pursue a passion. You may decide to use your RMDs to fund travel in a far-off destination or take the family on a tropical vacation. Or perhaps you’ll use this money to upgrade your home. Lifelong learners might invest in classes at the local community college. There are countless possibilities to use your RMDs, however you see fit.

If you need help deciding how to spend this hard-earned money, meeting with a financial advisor can help illuminate options that make the most sense for your individual circumstances and priorities.

Bill Kelso, CPA, CFP®, is a financial planner* at Pinnacle Financial Advisors, which assists individuals, families, and businesses with financial planning and wealth management in Sedona and the Verde Valley. He is a Registered Representative offering Securities through UNITED PLANNERS FINANCIAL SERVICES, Member: FINRA, SIPC. *Advisory Services offered through SEROS FINANCIAL, LLC. Pinnacle Financial Advisors, Seros Financial, and United Planners are independent companies.