The Secure Act increased
the required minimum distribution (RMD) age from 70 1/2 to 72, marking the
first change to the RMD age since first becoming law in 1986. The age
increase will only apply to anyone born on or after July 1, 1949. Now that some
taxpayers will be able to defer distributions from retirement accounts until
age 72, should they? It turns out, tax-deferred growth isn’t always a
no-brainer.
First, as a practical matter, many retirees
can’t actually afford to hold off on using their retirement savings until they’re
72. Even for those who can wait until they reach RMD age, it might not make
sense to. The ‘right’ withdrawal strategy will depend on multiple factors,
which change over time along with the laws, tax code, and the individual’s
personal financial situation.
Here are some of the important considerations
to discuss with your financial and tax advisor as you draft a retirement income
strategy.
Taking advantage of
low tax brackets
Especially for investors who have already
retired, tax planning can really pay off. If you’ve already retired and don’t
need income from retirement accounts before age 72, you could be living off
funds from a taxable brokerage account and perhaps Social Security, too.
Depending on your finances, this could land you in some of the lowest tax
brackets.
In 2020, married couples filing jointly are in
the 12% marginal tax bracket until $80,250 of taxable
income before progressing into the 22% rate on the next dollar of income.
For couples with less than $80,000 in taxable income, they may pay no tax at
all on long-term capital gains!
In this type of situation, it could be
advantageous for taxpayers to consider accelerating the realization of income
to ensure they’re able to take full advantage of a favorable tax bracket. With
some planning, you could calculate how much to take from tax-deferred accounts
to stay under the next marginal tax bracket increase (or whatever metric makes
sense for your tax and financial situation).
Of course, there’s always a tradeoff. One of
the disadvantages of this strategy is that you’re withdrawing invested funds
before you need them, losing out on potential (tax-deferred) investment growth.
The additional funds, now very accessible, could also tempt you to increase
your lifestyle spending, which could hurt your retirement plan in the long run.
Reinvesting money you don’t need in the short term in a taxable brokerage
account can help you avoid lifestyle inflation.
Reducing the tax
impact of required minimum distributions
To understand how RMDs can impact your tax
situation, it’s helpful to see how these distributions are calculated. Required
minimum distributions are computed by dividing the account balance of
tax-deferred (non-Roth IRA) accounts as of December 31st of the
previous year over the corresponding distribution period from the IRS’ Uniform Lifetime
Table, which is based on your age on your birthday this year.
For example: Ted will turn 76 in 2020. He has
one traditional IRA worth $2,000,000 on December 31, 2019. His RMD in 2020 will
be $90,909 ($2,000,000 / 22).
Since investors can’t control the denominator
of this equation, which is set by the IRS, they’d need to reduce the numerator
if they want to lower their required minimum distribution.
Put another way, to reduce your required
minimum distribution, you need to have less money in your traditional IRA (or
401(k), 403(b), etc.). Generally, this could be achieved by changing your
investment mix to reduce account growth (which likely doesn’t make sense as a
pure tax-reduction strategy), giving some or all of your RMD to charity through
a qualified
charitable distribution, converting assets in a traditional IRA to a
Roth IRA, or reducing your account balance by taking withdrawals (which is the
focus of this article).
Investors with large sums in tax-deferred
retirement accounts may see sudden unfavorable changes to their tax situation
when required minimum distributions begin. For these taxpayers, starting
withdrawals in advance of RMD age may be able to help mitigate negative tax
implications if they’re able to maintain a more balanced tax situation over
time.
Aside from paying more in taxes, high RMDs can
also increase Medicare Part B and D premiums. In 2020, married couples with
income over $174,000 (which is based on the prior, prior year tax return, or 2018
in this example) could see their
costs increase by $70, per person per month. Couples with income
over $218,000 will pay even more.
This is a good example of why it’s so complicated – all of these areas of our
financial lives are so intertwined.
Ultimately, planning will be personal to each
individual’s situation. It’s important not to compromise the health of your
overall financial circumstances in an effort to reduce tax. The ‘RMD tax cliff’
doesn’t impact all taxpayers and even when it does, the benefits of beginning
withdrawals earlier might not justify the loss of tax-deferred investment
growth. Other uncontrollable factors, like a severe market
downturn at the start of retirement, could also disrupt well-laid
plans and even make a case for staying invested.
IRAs are now less
effective as a legacy planning vehicle
Another aspect to consider when determining
when to start distributions from retirement accounts is an individual’s family
situation and legacy goals. The Secure Act marks the end of
the stretch IRA for non-spouses, so leaving a large traditional
IRA could cause some tax headaches for the next generation.
Starting in 2020, non-spouse beneficiaries of
a retirement account can no longer take distributions over their lifetime.
Instead, new inheritances must be taken by the end of the 10th year following
the year of death. For adult children in their prime working years, inheriting
a large retirement account could complicate their tax situation.
On the other hand, inheritances left in
taxable accounts currently have no draw-down requirement. Further, these types
of assets also receive a step-up in basis, meaning the beneficiary’s cost basis
for tax purposes is ‘stepped up’ to the fair market value of the account on the
decedent’s date of death.
For retirees who prioritize their legacy
goals, it may make sense to begin tapping retirement accounts before age 72 and
preserve taxable assets instead.
Stay tuned
The Secure Act brought the most significant
changes to the retirement system in over a decade. And though it’s the law
today, who knows what may change in the future. Maintaining flexibility in
whatever plan makes sense for you now and revisiting periodically, is
advisable.
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