By Justin Haschke, CPA, CFP
You know what they say: The government giveth and the government taketh away. That’s especially true about taxes. Each time a new tax law passes it lowers some taxes, but raises others. That’s what’s happened around with the new rules around required minimum distributions, or RMDs.
When Congress passed the SECURE Act in 2020, it substantially changed how RMDs worked. On the one hand, it raised the age at which owners of individual retirement accounts (IRAs), SEP IRAs, Simple IRA and traditional 401(k)s must start taking RMDs—from 70 ½ to 72.
There is even a proposal in Congress, though not yet passed into law, to push mandatory withdrawals out further still. If that proposed law, Securing a Strong Retirement Act of 2022, also known as the SECURE Act 2.0, passes, it would let retirees delay RMDs until age 75.
Benefiting from extra time
For the time being, the SECURE Act of 2020, which stands for Setting Every Community Up for Retirement Enhancement, gave retirees an additional 18 months to grow their retirement savings before having to pay taxes. In addition, the law removed the age limit for making retirement plan contributions (it had previously been 70 ½). These changes are an acknowledgement that people are living and working longer, so it makes sense to let them save longer and start withdrawals later.
That’s good news for people who don’t intend to tap their retirement accounts for living expenses. By leaving retirement accounts alone, they can grow without being taxed. In general, the longer you wait to pay taxes, the greater your tax benefit.
A compressed time frame for beneficiaries
The move to delay RMDs until 72 is estimated to cost the Treasury $8.9 billion in lost tax revenue over a 10-year period. To make up for that shortfall, there’s another provision in the SECURE Act that isn’t so favorable, and its purpose is to increase revenues. That’s the government taking away.
Prior to the SECURE Act, people who inherited a traditional IRA or 401(k) stretch out RMDs based on their lifetimes. A 40-year old would have been able to stretch out distributions from the account for decades. That gave them the ability to take out small amounts to keep themselves at the lower tax brackets.
The SECURE Act changed that. Now those who inherit IRAs and 401(k)s only have 10 years to take all their distributions, either by taking periodic withdrawals or in one lump sum. If someone inherits a sizable retirement account, that could mean a substantially higher tax burden.
That’s why when we do retirement planning with our clients, we’re looking at not just ways to minimize the tax impact for them in retirement, but also for the next generation. The good news is that by being strategic and starting early, we can time Roth conversions to accelerate income in a tax efficient way, allow your money to grow for a longer period of time and ultimately increase your nest egg.
Planning for two generations
As a hypothetical situation, a retired couple with high paying jobs while they were working have large retirement savings accounts, including IRAs and 401(k)s, with all pretax money.
With no additional planning they could be facing a tax torpedo (high RMDs causing more of their social security to be taxable and higher Medicare premiums due to their income levels from the RMD). Additionally, due to the Secure Act changes to inherited IRAs, they could also pass on a large tax burden to their children.
Depending on the other flows of income, it could make sense now to do Roth conversions from the pretax accounts, prior to turning age 72 to ensure paying a lower tax rate now and helping to diversify their retirement buckets of funds.
Additionally, their RMDs could also result in them having to pay a much higher rate for Medicare Part B, jumping to $300 each from the $157 they would have to pay if they were in a lower tax bracket. On top of that, taxpayers in the highest tax bracket are so subject to the income-related monthly adjusted amount, otherwise known as IRMAA, essentially a surcharge added to Part B and Part D premiums, so they would have to pay that too.
By working with a planner this hypothetical couple could a conversion of $140,000 out of their traditional IRAs and 401(k)s into a Roth IRA which grows tax-free and does not tax withdrawals, although contributions are made with after tax dollars. In other words, the yearly contribution into the Roth is considered ordinary income and taxed as such. By keeping the rollover amount under $140,000, this couple could stay in the 12% tax bracket they currently are.
The rollover also reduces the size of the IRA that their children will ultimately inherit, resulting in fewer taxes for the next generation.
Plan for spouses too
Another hypothetical situation involves a partially retired individual. He’s in his late 50s. While his IRA is worth about $1 million, his spouse does not have any retirement accounts of her own. If this individual’s salary is about $80,000, but he also a has a farm and the couple’s effective rate is around 10%.
Their goal is to maximize retirement income for them. Again, we are employing a conversion strategy because this client’s current tax rate is so low. What’s also helping us execute this tax strategy is the recent drop in the stock market. As the market value of securities held within the IRA decline, we can convert that smaller dollar amount to a Roth. When the market rebounds, the future appreciation will take place in the Roth where no income tax will be owed and no RMDs will be required for the account holder.
Spouses can also take advantage of another strategy to minimize the taxes for their heirs: At the time of the first spouse’s death, it may be advantageous to name the children as partial primary beneficiary they can begin to take funds now from that account at potentially lower rates than waiting until the second death to pass on the assets. It is always important to this strategy only works, as long as that money isn’t needed for day-to-day expenses for the surviving spouse, so reviewing plans regularly are important. This way, beneficiaries will inherit a smaller IRA at the time of the second spouse’s death and also extending that asset another 10 years after the second spouses death.
Start your planning early
Don’t wait until the year you turn 72 to start thinking about your RMD strategy. The more time you reserve for planning, the more flexibility you will have. Starting this process early gives you time to reduce your tax liability by shifting more of your retirement savings to a Roth IRA.
What’s more, we strongly encourage our clients to involve their accountants in the process so we can get a better sense of the tax picture.
As you can see the changes to the RMD rules can have a positive effect as well as a challenging one. By working with your financial advisors and accountant early, you have the opportunity to create a retirement withdrawal plan that minimizes your family’s tax burden while also increasing your retirement income.
This is piece is not intended to provide specific legal, tax or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
Converting from a traditional IRA to a Roth IRA is a taxable event.
A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.