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.
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.
This article was written by Darrow advisor