They are, as a rule, among the more unexciting words in the English language: required minimum distributions.
Today, though, RMDs—the annual withdrawals that many people, starting in their early 70s, must take from their nest eggs—are generating a surprising amount of noise and anxiety among retirees and financial advisers.
Recent changes in tax rules, courtesy of Congress and the Internal Revenue Service, could force some retirees and eventually their beneficiaries to pull more money, faster from tax-deferred retirement accounts than previously planned. These withdrawals, coupled with looming increases in tax rates, could leave families with much less money in their pockets and much more in the government’s.
A $1 million IRA, for instance, that only recently could have provided a retired couple and their heirs with payouts for 40 or 50 years might need to be emptied now in half that time. A smaller window translates into bigger required withdrawals each year. And bigger withdrawals mean bigger taxes.
More bluntly, a sizable balance today in an IRA or 401(k) could be “a ticking tax time bomb,” says Ed Slott, an IRA expert in Rockville Centre, N.Y.
What to do? If you have an IRA or 401(k) that amounts to a healthy six figures or more, it’s essential to stop thinking about required distributions simply as an annual task and begin thinking about RMD planning. That means steadily trimming the size of tax-deferred accounts to minimize required distributions and their associated taxes in retirement.
“It’s the RMD mind-set that needs to change,” Mr. Slott says. For decades, people planning for retirement have pumped money primarily into tax-deferred vehicles like IRAs and 401(k)s, as opposed to tax-free accounts such as Roth IRAs, and pushed off withdrawals from these accounts for as long as possible. Today, given the changes out of Washington, a better approach—particularly for those with large nest eggs—would be to “get those funds out of IRAs over a longer time period and take advantage of today’s historically low tax rates,” Mr. Slott says.
But “people generally aren’t doing this,” he says. “And that will cost either them or their beneficiaries over time.”
Not your decision
To understand why RMD planning is so important, it’s important to understand this: While most people decide for themselves how to manage their money, that isn’t the case with RMDs. The government makes you pull money from IRAs and the like on its schedule—not yours.
If you’re lucky, tax rates will be low when you have to withdraw funds, as they are currently. Today’s rates and tax brackets, though, are scheduled to “sunset” (read: expire) after the 2025 tax year and revert to their higher 2017 levels. Worse, the long-term outlook for tax rates is discouraging, at best. With programs like Social Security and Medicare badly in need of repair—and with the national debt recently topping $31 trillion—“the least likely thing is that taxes will go down from here,” says Doug Ewing a senior consultant in Denver with Nationwide Retirement Institute. “So why not take advantage of where we are right now?”
To get an idea of how attractive rates are today—and how quickly that can change—Mr. Ewing offers this example: Consider a married couple, both age 65. Let’s say this couple pulls $112,250 from a traditional IRA. (That figure takes maximum advantage of the current standard deduction of $28,700 for a couple this age.) If the couple has no other income, and if we use 2022 tax brackets, the federal tax on the withdrawal would be just $9,705, an effective tax rate of just over 8.6%, Mr. Ewing says. Fast forward to 2026, when tax rates revert to 2017 levels. Now, the same withdrawal results in a tax of almost $13,600, or an effective tax rate of 12%. (Note: The 2017 numbers will be adjusted for inflation, which could result in a smaller tax increase.)
Today, families and their advisers also must contend with one of the biggest changes in retirement finances in years. Congress, as part of the Secure Act in 2019, largely eliminated the so-called stretch IRA. As such, many beneficiaries who, before the Secure Act, could stretch withdrawals and taxes from inherited IRAs over decades now must empty these accounts within 10 years. Again, that truncated time frame means bigger annual withdrawals and bigger taxes.
In short, a nice, fat IRA, which certainly seemed like a worthwhile goal 30 or 40 years ago, today is doing many retirees and near-retirees no favors. All of which argues for RMD planning: anticipating how required withdrawals could affect your taxes and your beneficiaries’ taxes.
“A good tax projection looks out years in advance for key events,” says Martin E. James, a certified public accountant in Mooresville, Ind., who specializes in tax saving and asset-protection strategies. “What happens to my taxes when I claim Social Security? What happens when my RMDs start? What happens if one spouse dies? How will that affect the surviving spouse’s taxes?”
The point: “I want to be in control of my tax brackets when these events occur,” Mr. James says. “I don’t want these big spikes in my retirement income. And that’s where RMD planning comes in.”
What are some of the basic elements of that planning? Here are five:
If you’re still early in your retirement planning—and if you anticipate having the resources to build a big nest egg—you probably should move, if you haven’t already, to contributing to Roth IRAs and Roth 401(k)s, instead of tax-deferred accounts. Withdrawals from the former, of course, will be tax-free. As they will be for your beneficiaries.
The problem: Many investors are reluctant to do this. That’s because when you contribute to a traditional IRA or 401(k), you typically get a tax deduction up front. And we love that! We love what that immediate deduction does for our tax returns each year. But that approach also can be shortsighted.
Example: Let’s say you’re 15 years or so from retirement and currently in the 22% tax bracket. You contribute $25,000 to a tax-deferred account. As such, you save $5,500 today in taxes. Sounds good. Jump ahead to retirement, when this $25,000 contribution, ideally, has doubled in size. But now, you’re in the 25% tax bracket (if tax rates, at the least, revert to 2017 levels). If you withdraw $50,000 from this account, the tax will be $12,500 (0.25 x $50,000). If you had contributed the original $25,000 to a Roth, your tax on the $50,000 withdrawal would be zero.
Says Mr. Slott: “Tax deductions for retirement contributions are really just a loan from the government that will have to be paid back at the worst possible time—in retirement and at possibly higher tax rates.”
Start tapping IRAs early
Again, most people are loath to withdraw funds from tax-deferred accounts until the IRS makes them. It’s the mantra that has been part of retirement planning for years: To meet spending needs in later life, pull funds from taxable accounts first, followed by tax-deferred accounts and, finally, tax-free accounts.
For the better part of a decade, though, research has shown that blending withdrawals often can be more effective. That means pulling funds—say, beginning in your early 60s—from both taxable accounts and tax-deferred accounts, a so-called proportional approach. In doing so, you can chip away at IRA balances, as well as future taxes, a decade or so before RMDs kick in.
For example, a seminal study in the Journal of Financial Planning compared 15 methods of withdrawing funds from a $2 million portfolio with a 70-20-10 mix of, respectively, tax-deferred, taxable and tax-free assets. The authors found that, over the course of a 30-year retirement, a couple would pay about $225,000 less in taxes by tapping the tax-deferred account first (up to the level of one’s taxable deductions) and then tapping a taxable account, compared with withdrawing funds in the traditional manner.
This is an oldie but a goodie. For those approaching, or early in, retirement—and, typically, before RMDs begin—shifting funds from tax-deferred accounts to tax-free accounts (also known as a Roth conversion) is key.
“Many people don’t understand how powerful conversions can be,” says Aaron Kaplan, a lawyer in Cincinnati who specializes in estate planning. “Yes, you take a hit upfront when you pay taxes on the conversion itself. But you’ll be funding an account [a Roth IRA or Roth 401(k)] that won’t incur any taxes during the owner’s lifetime—or the beneficiary’s lifetime.”
Indeed, the larger your IRA balance, the more likely a chunk of those funds will end up in the hands of adult children or grandchildren. Again, these heirs, under the new rules, will have just 10 years to empty, and pay the taxes on, a tax-deferred account. What’s more, some of your beneficiaries could be inheriting your nest egg at the worst possible time: when they are in their own high-earning years.
Roth conversions do have their skeptics. A primary concern is “lost opportunity cost.” The argument goes something like this: “Why should I pull funds early from my IRA and pay taxes upfront? I would rather keep that money (the money that would be lost to taxes) invested in the markets and working for me.” The math, though, argues otherwise. Mr. Slott offers the following example:
A couple has an IRA valued at $100,000. They decide against converting to a Roth; they think it’s a mistake to pay the taxes upfront. If the IRA doubles in value over the couple’s lifetime to $200,000—and if the tax rate when they withdraw those funds is 30%—they will end up with $140,000 ($200,000 less the $60,000 paid in taxes). The couple’s next-door neighbors also have an IRA worth $100,000, and they decide to convert to a Roth. If the tax rate is the same 30%, the tax upfront on the conversion is $30,000, leaving the couple with $70,000 in a Roth IRA. If this amount doubles in value over their lifetime, the couple ends up with $140,000—the same amount as the couple who decided against converting.
“If both the tax rate and the investment rate are the same, there’s no difference in paying taxes upfront or later on,” Mr. Slott says. “However, if tax rates increase, then the Roth IRA advantage compounds over time.”
This strategy takes advantage of the fact that proceeds from life insurance typically are free of income tax.
Here, you use withdrawals from an IRA to purchase permanent life insurance—say a whole-life policy or universal life insurance. Yes, you’re taxed on the amounts pulled from your nest egg, and the annual insurance premiums can be steep: typically, $20,000 or more to buy $1 million or more of insurance. Which argues for starting this process, say, in your early 60s. The earlier you buy, the larger the death benefit for the same premium.
The long-term benefits, though, can be considerable. The assets inside the insurance policy grow tax-free; the insurance can be left to a trust, which can help you control, if you wish, the disbursement of funds after your death; and the proceeds paid to heirs will have no RMDs and, most important, no taxes.
All of the above presumes that you can, in fact, use part or all of your IRA withdrawals to buy insurance. (Your own short-term financial needs in retirement might preclude this.) Clearly, this kind of planning calls for sitting down with a financial adviser.
If you donate money regularly to charities, and/or if you plan to leave some of your estate to a charity after you die, two strategies can help with RMD planning.
The first is a qualified charitable distribution. A QCD—available to those age 70½ and older—is a direct transfer of funds to an eligible nonprofit from an IRA. (The money doesn’t pass through your hands; your IRA custodian handles the transaction.) The good news: You aren’t taxed on the withdrawal, and the withdrawal could count toward satisfying some, or possibly all, of your RMD for the year.
The better news: These distributions can help gradually reduce your IRA balance, which can help reduce the size of your RMDs, which, in turn, can help reduce your taxes. All this while still helping the charities you would have contributed to anyway.
The second option is a charitable remainder trust. This gets more involved, but the idea is relatively straightforward. You designate the tax-exempt CRT as the beneficiary of your IRA. (“Tax exempt,” as in the entire IRA goes into the trust without being taxed. And the assets, once inside the trust, continue to grow tax-deferred). After you die, the trust distributes a percentage of the assets annually to your survivors; at their death, the remaining assets go to a designated charity.
The larger points: First, a CRT comes close to re-creating some of the biggest benefits of the stretch IRA in that it is a tax-deferred vehicle that generates a lifetime stream of income. Second, when it comes to postdeath charitable planning, your IRA might be the best asset to leave to a CRT. Leave other non-IRA assets to your family.
This article was originally published in The Wall Street Journal on November 28, 2022, and written by Glen Ruffenach.
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