Allworth Co-CEO Scott Hanson reviews three different ways retirees can lower their RMDs and tax burden.
Here are two questions, one intended for those of you who have yet to retire, and the other for those of you who have already retired.
First, pre-retirees: Do you think your tax bracket will automatically be lower once you stop working?
Second, for retirees, has your retirement tax bracket been higher or lower than you expected?
Each year, tens of millions of people prudently save money in a defined contribution plan (such as a 401(k)), or some other tax-deferred retirement account (such as an IRA).
No problem there.
Most people use these vehicles because they are a great way to save for the future.
But my experience has been, unfortunately, that a lot of folks retire and then, once their required minimum distributions (RMDs) from their retirement accounts kick in (at either age 70½, or 72), they end up paying taxes at a rate that is equal to, or even exceeds the rate they were paying before they stopped working.
When good savers retire and combine Social Security, RMDs, and other income streams, they can find themselves in a tax bracket that is identical to (or even higher than) the one they were in at the height of their earning power.
And this higher tax bracket impacts their quality of life at a time when they’ve accumulated pretty much all the money they’re ever going to save.
That’s because all-too-often, either via planning mistakes or a lack of foresight, retirement tax-rates don’t drop as much as people expect them to.
And a key reason is because the balances in their retirement accounts, which have been growing tax-deferred for years - or even decades - necessitate these often surprisingly sizeable (and highly taxed) RMDs.
How RMDs are calculated
Now, before I get into some strategies that could help you lower your retirement tax burden, a quick word about how RMDs are calculated.
Each year, the government adds together all the money in your tax-deferred retirement accounts and divides it by several different calculations, including your life expectancy. The older you are, from a percentage standpoint, the larger your RMDs will likely be. And the larger the RMD (the amount you must withdrawal each year, starting at either age 70½ or 72), the higher your tax burden is likely to be. Unless you plan.
Okay, so perhaps you’re thinking that you’ll just have to pay a few more dollars in taxes on a large RMD withdrawal, right?
Wrong. Remember, the tax on your RMDs doesn’t occur in a vacuum.
Simply, it’s not just that the RMD is taxed; it’s that the money from that withdrawal is applied to all your taxable retirement income. So, if your retirement income jumps by, say, $70,000 because of the size of your RMD, and your overall tax burden gets bumped up by, say, 10 percent? Or, maybe more?
You could find yourself forced to pay tens of thousands of extra dollars in taxes than was absolutely necessary.
One answer could be to lower the size of your RMDs.
What follows are 3 RMD strategies that could lower your future tax burden and save you money.
Strategy #1: Take withdrawals earlier
Typically, the earliest you can begin taking withdrawals from your tax-deferred retirement accounts is at age 59½. (You can take money out before, but you’ll get hit with a 10 percent early withdrawal penalty.)
But if you work with a fiduciary advisor to calculate how much money you can start taking out of your 401(k) (or IRA) after you hit age 59½, but before you are forced to take RMDs?
You may enjoy two future benefits:
First, taking withdrawals earlier may enable you to delay taking Social Security. And because each year that you wait (up until age 70) to apply for Social Security means your benefit amount increases by eight percent, you’re looking at a not-unsubstantial increase to your monthly income. (This, of course, does not take into consideration possible future legislative changes that may be coming to Social Security.)
Second, drawing down your tax-deferred retirement accounts earlier should reduce the amounts of the IRS mandated RMDs that you’ll legally have to take, and this potentially decreases the odds that you’ll get bumped into a higher bracket that will unnecessarily eat up your money.
Unfortunately, most retirees aren't doing this kind of advanced planning. The majority (80%) don't take their RMDs before they're required, which, as I've just noted, is a missed opportunity.1
Strategy #2: Give the RMD to charity
For exceptionally good savers, there is a terrific way to meet your RMD requirement and pay absolutely no taxes on it.
Once you hit the age where you must take RMDs, turning that withdrawal into a qualified charitable distribution (QCD) by directly transferring the funds to a charitable entity could be a viable strategy for some people.
While I encourage you to speak with your advisor before following this route, here are some basic considerations regarding the process of transferring your RMD directly to a non-profit.
First, the custodian of your IRA must transfer the funds directly. (You can’t touch it.) Next, while you can’t “double dip” and later claim the charitable transfer on your taxes as a deduction (because it doesn’t count as taxable income), the beauty of this is that it potentially keeps you from being shoved into a higher tax bracket.
A third, and not insignificant, consideration to all of this is that giving money to a well-run charity is a heck of a nice thing to do.
Strategy #3: Roll the money in your IRA into a Roth
While there are numerous calculations that are required to determine if the following strategy makes financial sense, because Roth IRAs never require RMDs, a few of the scenarios whereby rolling the money from your IRA into a Roth IRA could be advantageous, include:
- You’re going to be in a higher tax bracket when you use the money.
- You know you want to reduce the amount of your future RMDs.
- You want to pass money along to your family that is tax free.
Remember, while you’ll have to pay income tax on the money you transfer from your traditional IRA (into the Roth IRA), you get to reinvest that money in a vehicle where it will grow tax free and not ever be subjected to RMDs.
When it comes to retirement, and to both legally and ethically keep as much of your hard-earned cash as possible, there are obviously a lot of things to consider.
I end a lot of articles with some version of what I’m about to say, but that’s because I strongly believe that what we do at Allworth Financial helps people achieve their financial goals and positions them to better enjoy a lifestyle of their choosing.
Simply, the strategies above are complex processes, and just potential suggestions for your overall financial plan, all of which are of course intended to help you retire better.
Please speak with your fiduciary advisor before using these, or any other strategies, related to investing, taxes, finance, or retirement.