Yes, that’s right–I said it: sometimes, the IRS is fair in financial planning. One case this is true is in how IRA required minimum distributions are treated.
Seasons of Life and Financial Planning
Throughout our lives, we have rites of passage. On your first birthday, that might be plunging your face into your cake. At age 10, it’s achieving double digits. At 16, getting a driver’s license. At 18, being a legal adult and voting. At 21, buying alcohol and moving beyond most of the legal limitations of youth. At 25, being able to rent a car without extra fees or hassle. At 30, maybe you feel like a grown adult or are realizing that you are not a child anymore. At 35, you are old enough to be elected President! And then, ages 40, 50, and 60 can be meaningful markers in the journey of life.
In the financial planning world, some of the significant age-based milestones are related to the treatment of retirement accounts like IRAs.
At age 59½, you can pull money out of your IRA with no early withdrawal penalty. Before this age, a 10% penalty applies.
Age 62 is the earliest that you can start taking your own Social Security benefits.
When you turn 65, you reach the traditional golden retirement age, which these days means… almost nothing. Well, you are eligible for Medicare. If you have a pension, age 65 may still be an important age.
Until 1961, 65 was the age to start collecting Social Security benefits. However, since a 1983 law change, options have proliferated, and the decision has become more complex. Most people can choose to start their benefits between the ages of 62 and 70.
Fun Fact 1: If you were born in 1960 or later, then you cannot start your “full” benefit until you turn 67.
Will You Still Need Me, Will You Still Feed Me, When Will You Start Making Me Pay Taxes?
When I’m 70½? That’s your IRA asking you the question that was famously and much more eloquently asked by The Beatles, by the way.
At age 70½, we arrive at the last major age-based financial planning milestone. Technically speaking, the deadline is April 1 of the year following the year you turn 70½. For obvious reasons, we are going to simplify that to say age 70½.
Note: In this article, I discuss traditional IRAs because that is where the vast majority of people age 70+ have their retirement accounts. Similar rules apply to 401(k)s and other retirement plans–but again for simplicity, I’ll focus on traditional IRAs. Roth IRAs do not have a Required Minimum Distribution, which is one of their key differences and beyond the scope of this article.
Someone who reaches age 70½ with money in a traditional IRA is confronted with an interesting IRS rule. The rule requires the account holder to make a withdrawal each year and add it to their taxable income. These withdrawals are called a Required Minimum Distribution (RMD).
This part of the tax code in financial planning is quite clear in its naming. Required, Minimum, Distribution.
1) It is Required, or you face a 50% penalty on what should have come out.
2) A Minimum amount must be withdrawn to avoid this punitive penalty.
3) It is a Distribution, i.e., it must come out of your IRA.
There’s Something About Mary’s IRA
Let’s look at Mary, a hypothetical 70½-year-old retiree. Mary arrives at this important half-birthday, and now it’s time to withdraw the money to keep the IRS happy. She has done well for herself by saving outside her IRA, having other income sources including Social Security benefits, and living a reasonably modest lifestyle. Therefore, she does not need money from her IRA to live on. She would prefer for it to continue to grow entirely tax-deferred. You can see why Mary might be somewhat miffed at the IRS forcing her to make withdrawals that add to her tax liability. She may say, “Why must I pay extra taxes? I don’t need the money. This isn’t fair!”
OK–I hear you Mary, and I understand why more taxes might feel unfair. But let’s take a step back and ask: why does the RMD exist?
The IRA is set up to give the owner a way to save and invest before their paycheck is taxed. These before-tax contributions are then allowed to (hopefully) grow over time without any interference from taxes. Only at the time of the withdrawal are these deferred gains subject to income taxes.
Back to Mary. Picture her at age 40–thirty and a half years ago–and imagine that she had been a steady earner and saver since she entered the professional workforce in early her 20s. Thanks to her diligence at a young age and some investment gains, she accumulated $100,000 by her 40th birthday. For simplicity, I will not address the tax deferral up to that point.
Now, let’s pretend that Mary does not contribute another penny to her IRA. If she were able to earn 7.84% per year, compounded over the ensuing 30½ years, then she would end up with $1 million today at age 70½. Certainly, no guarantee of that level of growth would happen, but it is not historically unusual either. I use it here only to provide us with a nice round number.
Mo’ Money, Mo’ Problems
Let’s consider what that round number means. Mary, without contributing a dime (or a nickel or a penny) has increased the size of her account tenfold–without losing even one dollar (or quarter, or… you get the idea) to the impact of taxes! Nine hundred thousand dollars of growth with $0 taxes. Nine-tenths of a million dollars, zero taxes. Not bad.
This is really remarkable when you consider how many taxes you pay throughout your working lifetime: federal income taxes, state income taxes (in most states), Social Security taxes, Medicare taxes, property taxes, sales taxes, capital gains taxes, dividend and interest taxes, hotel taxes, and gasoline taxes, just to name a few of the major ones. Having an asset that dodges the impact of the IRS for that length of time and that dollar amount is an amazing benefit of the tax code.
“That’s all well and good,” Mary says. “But now what? I’m about to lose the benefit of not paying taxes on my account!” Ah, but take a closer look, Mary.
She’s arrived at age 70½, and it’s time to finally pay the RMD piper (this piper apparently had the last pick of the piper names, way after “pied piper” was drafted #1). But how much?
Only Two Things in Life are Certain… And Taxes are the Better Option
What exactly are the mechanics that trigger the Required Minimum Distribution? The first part of the deal with the IRS is that no taxes were due on the money earned or any growth for those 30 or 40+ years that Mary had her IRA. The second part is that the IRS will now tax a relatively small slice of her IRA money each year. She will be Required to make a Distribution of a Minimum of 3.65% of her account that first year. Calculated another way: take the balance and divide it by 27.4–that is your RMD. For Mary, that means withdrawing about $36,500 from her $1,000,000 IRA.
Tip: For the first year, the withdrawal does not need to happen until April 1st the year after you turn 70½, but it may not be wise to defer into a new year. For every year after that, the withdrawal must occur before the end of the year. So, if you defer payment until April 1st, then in the second year you will have two distributions, potentially bumping you into a higher tax bracket.
Mary scoffs, “See! I told you it isn’t fair–$36,500 of extra taxes is outrageous.”
Ah, but Mary–we aren’t finished yet. Yes, you will have to take out $36,500, but that is not the same as paying $36,500 in taxes. That amount is added to your income to be used in calculating how much you pay in income taxes. This distinction is very important, so let’s repeat it. That money does not go directly to the IRS but is instead added to your yearly income. Be wary of anyone who uses scare tactics to influence your thinking and behavior–especially when taxes are involved.
To see the real impact, let’s say Mary has done very well for herself and is in the 24% marginal tax bracket. In 2018, anyone filing as a married couple with a taxable income of $315,000 or less would be at this rate or lower. Most people will be in a lower bracket. But to be safe, we assume Mary pays 24% on her $36,500, or $8,760 in additional taxes this year.
OK, Mary… you got me. Yes, you will have to pay almost $9,000 more taxes than you did last year. That is true. I don’t want to minimize how that must make you feel. I don’t advocate throwing a party to commemorate it. However, in context, we are talking about a million dollar asset… your IRA. The extra tax bill is less than 0.9% of the account value. It’s about 1% percent of that $900,000 of tax-deferred growth you enjoyed over the last 30+ years. This is money that has never been taxed–for 30 or 40 years. This annoying tax bill is a very modest percentage of your total assets–even if you end up with increased income that moves you to a higher tax bracket.
Some of Mary’s cohorts also accumulated a nice nest egg and still have a very reasonable lifestyle, especially relative to their assets. In retirement, some of them still have a taxable income under $75,000 (married filing jointly) and can live comfortably. In those cases, it is possible to be in the 12% marginal tax bracket. That would cut the example tax bill in half, down to $4,380 or less than 0.45% of the account value! Again, never fun, but a pretty modest levy on a million dollar asset.
So, to recap: Mary invests her money before it is subject to income taxes, lets it grow for 30 to 40 years without any taxes, and then pays around half to one percent of the value in income taxes the first year she is required to make a withdrawal.
Now, Mary’s thinking, “Hmmm. Maybe this isn’t such a bad deal, at least this year. But there has to be some catch. What happens next year? And the year after that?” OK, Mary–I get it. How does this work in the years after you turn 70½?
You Don’t Have to Spend Money to Make Money OR to Avoid a Penalty
Well, maybe there is a slight catch. But not much of one. The catch is that the IRS bases the withdrawal amount on your life expectancy, which they reduce each year in their calculation. They let you off easy the first year by only requiring you to take out 3.65% of your account balance. The next year and each year after that, the RMD will be a slightly larger slice of your IRA. However, it is a fairly slow ratchet: the next three years move that up only to 3.8%, 3.9%, and 4% of your account balance. It doesn’t exceed 5% until you are 79 years old, and it doesn’t reach 10% until you reach age 93.
That means that the other 95%+ of your account is not exposed to taxes in a given year until you are almost 80. And 90%+ continues to grow throughout your 80s and into your 90s. It is human nature to focus on what we lose to taxes each year, but it is vital to also pay attention to the part that we kept from the IRS along the way. It is possible that a successful investment plan could more than make up for the RMD withdrawals. You simply need to have average annual returns larger than the distribution percentage–which means your target is 5% per year or less the first 23 years.
Mary, use this information to put your worry in context.
1) You don’t have to spend the RMD! In all this talk about money leaving the IRA, it’s easy to think of the money going away since it is leaving the account we are concerned with. However, after your tax bill is accounted for, you can put the remaining funds anywhere you want. It is possible to never spend any of that–so only a portion of the RMD is lost to taxes, but the majority can simply be relocated. Imagine having all your IRA money in the attic, you take it all down, pay a slice of it in taxes, and then put the rest away in a different part of the house.
2) Many (most?) of your contemporaries have an IRA to generate income for themselves in retirement. You were wise to save money for later in life. Guess what? Now is later!! If you make regular distributions as a paycheck replacement to fund your living expenses, you receive credit for that in the RMD calculation. Any D (distribution) is credited toward your RM (required minimum) for the year. For example, if Mary took $4,000 per month when she hit age 70½, she wouldn’t have to change anything since that $48,000 per year would put her well past the $36,500 mentioned earlier. If you complain about the taxes on your RMD one day, it is very likely to be one of those good problems to have—it suggests that you don’t need your IRA at all because of your other resources.
Sound financial planning can help reduce both the annoyance and the total tax liability that the RMD might trigger. The IRS gives us an 11-year window where we can take out of the IRA without penalty, but we don’t have to. That window is from age 59½ to age 70½. Most people defer the withdrawals as long as possible, which often makes sense. However, if we see that the RMD is looming someday and we have some flexibility, it may make sense to use up lower tax brackets with IRA distributions. It may be more efficient to pay a little tax earlier to avoid or reduce higher taxes in your 70s and beyond. Consult with a tax and/or financial planning professional who understands the tax implications of withdrawals if you aren’t comfortable making them yourself.
The Only Thing You Have to Fear About RMD Planning are Gurus Selling Ideas Based on Fears of Paying Taxes
Any strategy that claims to reduce or avoid taxes tends to attract attention, so many marketing strategies are built around claims of tax efficiency. Some of them use the moderate taxes due on an IRA later in life, which is only half the story as we’ve seen, to promote the idea that using tax-deferred accounts is a terrible idea in the first place. Even well-meaning tax and financial planning professionals are prone to strategies that claim to minimize the lifetime tax burden on IRAs, such as converting to a Roth IRA. More about this in a later post.
Fun Fact 2: If you hear “401(k)s and IRAs are a scam,” then run the other way–fast! This person or organization is not dispensing sound and objective financial advice.
It is possible to take steps that may reduce your lifetime tax consequences. I caution you from putting too much confidence in any one tax planning approach that needs 10 or 20+ years to be worth the activity.
Here is a partial list of variables that you need to know to definitively compute if you will come out ahead:
- Tax rates in every year that withdrawals will be made. By the way, many experts have insisted for years that tax rates will go up, but the most recent tax law change in 2018 saw income tax rates go down.
- How long will you and your spouse live?
- Future tax law changes that alter incentives, cutoffs for certain advantages, i.e., phased out deductions or credits at certain income levels.
- How capital gains tax rates will change over the years between now and when you exhaust the account.
- If you want to leave your IRA to your children, you need to know their future tax brackets for the rest of their lifetime.
That’s All I Have to Say About That
The previous list is made up of things that are mostly unknowable. We can make educated predictions, but we are fooling ourselves if we don’t realize that they are just guesses. Therefore, using the power of the IRA’s tax deferral as long as possible and taking your RMDs when the time comes seems like the safest route to avoiding unnecessary income taxes on the account.
As the saying goes: life may not be fair, but the rules for IRA Required Minimum Distributions are. OK, maybe it’s not a “saying” (yet!), but it should be! If you have accumulated a nicely sized IRA and are frustrated by current or future RMDs, it is natural to focus on the tax bill. But please, Mary, look back at the incredible tax-deferred growth you’ve enjoyed–and look forward to hopefully having a lot more.