Updated following the passing of the Secure Act. Most working Americans save for retirement using an employer-sponsored retirement plan like a 401(k). Their pre-tax contributions reduce their taxable income in the current year while their retirement account enjoys tax-deferred growth. At age 70 ½, (or age 72 for individuals who turn 70 1/2 after December 31st 2019) individuals are forced to start drawing down assets in tax-deferred accounts like a traditional IRA, 403(b), or 401(k). For savers with one million or more in tax-deferred retirement accounts and other sources of income, these mandatory taxable distributions may be problematic.
How RMDs are calculated
To illustrate why RMDs may present tax planning challenges for those with a sizeable nest egg, we first need to explain how required minimum distributions are calculated. The IRS’ Uniform Lifetime Table uses age, the corresponding life expectancy factor, and the account balance(s) as of December 31 of the prior year for all retirement plans and IRAs (except Roth IRAs). This sum is then divided by the life expectancy factor listed on the table. (Note: The When a spouse is more than ten years younger and is also the only primary beneficiary the Joint Life and Last Survivor Expectancy Table is used to calculate RMDs instead.)
When do you have to start RMDs from retirement accounts?
The Secure Act, which was passed at the end of 2019, changed the age some retirees will need to begin RMDs. Individuals born on or before June 30th,1949 will need to take their first required minimum distribution at age 70 1/2 (though you may defer the first RMD until April 1st of the year following the year you turn age 70 1/2) which remains unchanged from previous legislation.
Investors who are born on or after July 1st 1949 will be required to take RMDs starting at age 72 (though they too can defer their first RMD until April 1st of the year after the year they turn 72).
RMDs must be taken by 12/31 for every year thereafter (though if you choose to defer the first RMD until April, you will need to take another RMD by 12/31).
How required minimum distributions can impact your tax situation
Although your income is likely lower than while you were working, retirees may find themselves in an equal or higher tax bracket during retirement due to the loss of previously-enjoyed tax deductions. Working professionals may reduce their taxable income through contributions to a tax-deferred retirement plan, health savings account, and through mortgage interest deductions, to name a few. However, as we age the availability of these deductions begins to fade.
Although tax-deductible contributions to a traditional IRA can now be made at any age, you must have earned income, which doesn't help most retirees. Further, Medicare enrollments at age 65 may impact your ability to stay on your employer’s high deductible health plan. Also, individuals in this age demographic are less likely to have a mortgage. So what does this mean?
For retirees with large balances in tax-deferred accounts and few remaining options to reduce taxable income, required minimum distributions may have a dramatic impact on your tax situation. RMDs will increase your taxable income, which can cause Social Security benefits to be taxed and Medicare premiums to be higher, and may phase out certain income-based tax deductions.
Social Security is at least in part taxable for individuals with provisional income of $25,000 or more and $32,000 for those that are married and filing jointly. If provisional income is greater than $34,000 for single filers and $44,000 for joint filers, it is likely that 85% of your benefits will be taxed. Although there is no way to predict future tax rates or legislative actions, by strategically diversifying the retirement portfolio, investors can give themselves more flexibility in retirement.
There is a lot to be said for the benefits of tax-deferred growth on an investment portfolio. However, for investors who are able, it may be wise to diversify retirement assets. It is worth noting that not everyone is expected to feel adverse tax consequences of required minimum distributions and depending on your tax projections for the future, it may not make sense to forgo tax-deferred growth.
There are three main investment categories for retirement assets: tax-deferred, taxable, and tax-free. Tax-deferred accounts are the most common; Traditional IRAs and employer-sponsored retirement plans are two examples. Investors are able to deduct contributions from their taxable income but will pay regular income tax when they withdraw funds in retirement.
Taxable accounts, such as a brokerage account, will require you to pay taxes on dividends, interest and capital gains on realized investment gains annually. There are benefits of saving for retirement this way: the funds can be used at any time in your life for any purpose, there are no withdrawal requirements, and taxes can be mitigated by using efficient investments and targeting long-term gains.
Tax-free accounts like a Roth IRA and Roth 401(k) are unique in that an investor will make contributions with after-tax money, but the account can then grow tax-free if held for at least five years. Distributions in retirement are not taxable, and there are no RMDs on Roth IRAs. Roth IRAs have income limits which preclude many investors from contributing. However, individuals are allowed to make one conversion from a Traditional to a Roth IRA annually, regardless of earnings. The catch is that the entire amount being converted is considered taxable income that year, which may bump you into a higher tax bracket.
If you are considering a taxable or tax-free strategy to diversify your retirement savings, make sure you have a strategy in place for ongoing regular contributions that will make a meaningful impact on your overall situation. If you only expect a small percentage of your investable assets to be diversified in tax-free or taxable accounts when you approach retirement, then you may benefit from just maximizing your contributions to tax-deferred plans.
Drawing down retirement assets
The order in which it is most advantageous for you to tap retirement assets will depend on your tax and income situation each year. As a general rule of thumb, retirees currently in a lower marginal tax bracket may want to draw down tax-deferred accounts first. Those still working or in higher tax brackets could benefit from withdrawing funds from tax-free or taxable accounts. If passing along a legacy to heirs is a primary goal, using taxable assets last may be a good strategy.
When developing a tax planning strategy, it is advantageous to stay focused on the big picture. While reducing taxable income is an important part to your wealth strategy, don’t let the tail wag the dog. In other words, make sure taxes are part of your plan – not driving it. Instead of spending too much time speculating as to where tax rates will go in the future, develop your retirement plan around your income and legacy goals.