Many people in the workforce have a retirement savings vehicle option available through their company benefits program. The most common are the 401(k) or 403(b). These retirement vehicles that allow people to save money in a tax deferred account and receive tax deferred growth throughout the course of their life.
This means that the money going into this account is not taxed at an individual's current income rate, but is deferred until that person decides to remove dollars from the account.
In many cases when individuals retire from or leave a workplace, they take their 401k/403b and roll it into an Individual Retirement Account (IRA). A "rollover" is a nontaxable event. An investor would choose to complete a rollover for a number of reasons, but most appreciate the opportunity to gain access to a wider diversity of investment options and to use the services of their preferred financial manager.
Individuals are allowed to start withdrawing money out of an IRA at age 59 ½ and will not be subject to a 10% penalty after this age. The key word with IRA is “deferred”.
Once you start taking money out of this account, it will be taxed at your ordinary income tax rate.
Let’s say you have $400k and decide to retire at age 62, you then decide to buy yourself something nice for putting in 30 years of work, so you withdraw $20,000. This withdrawal would have a tax implication of whatever your current tax rate is (10%,12%,22%,24%, 32%,35%, 37%). If you are in the 22% tax bracket you would owe $4,400 in taxes on that withdraw and would receive $15,600 after taxes.
Age 72- Required Minimum Distribution
Another caveat with IRA’s, is that the federal government requires you to start withdrawing money yearly at the age of 72. This process is called a “Required Minimum Distribution”. This number is calculated by taking the account balance at year end and dividing by the distribution period from the IRS’s Uniform Lifetime Table.
The IRS’s goal is for you to deplete your retirement accounts based off your life expectancy to ensure that taxes are paid on these earnings. One of the most common questions we get is: "What if I do not need the money during the RMD period, can I leave it in my IRA?"
Unfortunately, it doesn’t matter if you need the money or not, you must take the distribution or face a 50% penalty on that RMD amount. On the flip side, you can take your money from the IRA and put into a taxable brokerage account to reinvest the funds.
A huge conversation piece on the RMD front is will the IRS ever push the RMD age back because life expectancy is lasting longer and longer now days? There are proposed bills right now to do this and we saw it move up from age 70 ½ in 2019, after four decades of being stagnant. The proposed bill would push it out to age 75 by year 2032. Great news! You will get 3 more years of tax deferred growth in the account, and everyone is happier when they are not forced to withdraw money they may not need. Let’s examine some hidden reasons the IRS may decide to raise this age after forty years of being stagnant.
Hypothetically, you would have 3 more years of tax deferred growth in your IRA account. Let's consider how this would impact an account that has grown from $500k at 72 years old to $850k by the age 75. The RMD amount for $500k would be roughly $18,000 vs $31,0000 for the larger amount at age 75. The difference in these two numbers equals more tax dollars for the IRS. This larger reported income could bump you into the next tax bracket for income tax, cause more of your social security to be taxed, and could raise Medicare monthly costs.
Moving up from the 22% tax bracket to the 24% bracket is somewhat painful. However, an individual who jumps from the 10-12% to the 22-24% bracket is much more so! This problem will turn it any even bigger issue after the 2025 tax year when we revert to the pre-2018 higher tax rates and tighter tax brackets.
One of the biggest opportunities of delaying the RMD age is extending the window for Roth conversions a few extra years.
Roth Conversions
Roth Conversions are simply described as taking money out of one pocket and putting it into the other pocket. Typically, money is withdrawn from your IRA and then placed into your tax-free Roth IRA. During this process you will still have to pay taxes on the withdraw (there is no way to get around that). Why would you want to do this?
Some numbers may help shed some light on this process. Jane Doe retires at age 62 and has a 401k balance of $500k that she rolls over to an IRA. Once Jane retires, she will not get paid from her employer anymore and will have sustainably lower income. Assuming she elects to start receiving her pension and social security, she will receive 60k per year. Assuming a 7% return on investment, her account grows from $500k to $984k in 10 years. At age 72 her RMD would be $35,000 for the first year. This turns her 60k income into 95k (not including adjustments for pension and social security). Inadvertently this would push her from the 12% bracket to the 22% bracket.
Let’s not overlook the fact that because of the income increase, her Medicare premium went up from $170.10 per month to $238.10 per month and the next level would be $340.20 if the RMD amount grows. In this situation, it may have made sense to start converting funds at age 62 while in the 12% bracket.
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All withdraws from the Roth IRA are tax free and there are no required minimum distributions on Roth's. Another benefit is that Roth withdraws are not reported as income.
Tax Impact to Your Beneficiaries
Another tax fact to consider is what happens with the remaining retirement assets after the owner passes away. If there is no surviving spouse, the beneficiaries are typically the children of the decedent. Those who stand to inherit these accounts are typically in the highest earning years of their professional life and will only have 10 years to completely deplete the inherited account.
In our example, Jane Doe could have been paying 12% on IRA withdrawals, but when the asset passes over to her children, they may be in a higher tax bracket which would equal more taxes paid out of the account. If the inheritance is a large sum, this could create a tax burden on the beneficiary.
What can you do?
Don’t always assume waiting to take your RMD’s is the better choice. Consider consulting a financial planner to assist with this process. The most tax efficient strategy is typically getting the money out of the traditional IRA at the lowest rate possible, but waiting until the age of 75 may not be in your best interest.
Roth conversions typically makes sense when a person believes they will be in a higher tax bracket later down the road. With income taxes going up after 2025’s tax year and our country borrowing significantly more money than ever, there is a strong chance taxes will be higher for many people in the future.
We strongly encourage all our clients to consider at least a partial Roth conversion for these exact reasons. Please consult with the team at Creekmur Wealth Advisors to see if this makes sense for you and take control of your tax planning.
Sources:
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
