This blog has been updated with new information from its original version, previously published on May 15, 2023.
Planning for retirement involves many variables, which can make it quite challenging. A successful retirement plan involves identifying, analyzing, and maximizing your available options.
One often-overlooked component of retirement planning is the impact of required minimum distributions (RMDs). In this post, we'll explore what they are, recent legislation changes, and the potential impact on you and your heirs.
Congress enacted Internal Revenue Code Section 401(k) in 1978. We are just starting to see the first generation of workers retiring who were offered employer-sponsored retirement plans for their entire working careers. This has led us to a good problem: very large account balances!
But many of these workers will have high taxable income at their required beginning date. This generation of retirees is often surprised by just how much tax they will have to pay from their retirement accounts.
Many will face substantial RMDs given how much they saved over the past several decades. While saving is always a good thing, the tax ramifications need to be addressed.
What Are RMDs?
RMDs are mandatory withdrawals from certain qualified retirement accounts (e.g., traditional IRAs or employer-sponsored plans) at a specified age.
The purpose is to help spread out the distribution of your retirement accounts over your lifetime. RMDs ensure that you aren’t able to defer taxation until the money is inherited by another. They help generate hundreds of millions annually in tax revenue.
Generally speaking, RMDs are calculated by dividing the prior year-end balance by your IRS life expectancy factor. There are various calculators that can help you estimate your annual requirements.
Recent Changes to RMD Rules
Recent changes to the RMD rules may have an impact on your retirement planning. The first change was in 2019 with the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which raised the age for starting RMDs from 70 ½ to 72.
In December of 2022, Congress passed the SECURE Act 2.0, which, among other things, changed the RMDs for many Americans. If you turn age 72 after the 2022 calendar year, your RMD start date is based on the guideline below:
Birth year: 1951-1959 = Age 73
Birth year: 1960 or later = Age 75
The “still working” exception allows you to delay RMDs in active employer-sponsored plans [e.g., 401(k), 403(b), Thrift Savings Plan (TSP)]. This exception does not apply to IRAs.
Joe, age 77, has all his retirement savings in his IBM 401(k). Joe is not required to take RMDs as long as he continues to work for IBM. If Joe were to retire in 2026, then he would be required to take annual RMDs.
How the New RMD Rules May Affect Retirement Planning and Tax Planning Strategies
These changes have allowed many to delay their mandatory withdrawals, which can offer greater flexibility in retirement and can open up several tax planning strategies. Deferring withdrawals allows your investments to compound for a longer period. In addition, delaying them can reduce your tax burden in those respective years.
An effective strategy could be to delay withdrawals until later in retirement. This would allow you to maximize investment growth and provide a boost to your retirement income. Another strategy is to consider Roth IRA conversions, which can provide tax-free assets in retirement and reduce future RMD amounts.
Let’s take a look at an example:
Mary, born in 1954 (age 72), has a $2 million IRA. Thanks to the recent changes, her RMDs won’t start until 2027 (age 73). This allows Mary’s investments to grow uninterrupted for an additional year and save a considerable amount in taxes.
If not for the change, Mary’s RMD in 2026 would have been ~$80,000, which is ~$24,000 in taxes (assuming a 30% tax bracket). This additional income could have also pushed Mary into a higher tax bracket! In addition, her RMDs could subject her to Medicare surcharges, better known as IRMAA (income-related monthly adjustment amount).
Given Mary’s lower taxable income in 2026, it could make sense to withdraw a smaller amount from her IRA and pay the tax while in a lower bracket. If Mary truly does not need these funds for an extended period, she could explore Roth conversions, which could provide sizable tax benefits to both her and her heirs.
Now, the reality is that if Mary needs $80,000 from her IRA to meet her financial obligations, the potential tax benefits above are eliminated. With proper planning, Mary should have money in various tax buckets, providing the necessary flexibility to take advantage.
Overall, you need to consider how the new RMD rules may impact your retirement planning and tax strategies. Talking to a fiduciary fee-only financial advisor can help you develop a comprehensive retirement plan that considers your unique financial situation, goals, and needs. This can help provide peace of mind and financial security for you and your family throughout your retirement.
Impact of RMDs on Estate Planning
RMDs can have significant implications for estate planning, particularly if you plan on leaving a large amount of retirement savings to your heirs.
Spouses can inherit each other’s retirement accounts and transfer into their own without tax consequences. The problem arises when the inheritor is a non-spouse. The passage of the SECURE Act eliminated the stretch IRA and requires non-spouse beneficiaries to liquidate their entire account balance within 10 years of the original IRA owner's death, with few exceptions.
These withdrawals are taxed as ordinary income in addition to other income earned in those respective years. Failing to take RMDs can result in significant penalties, so beneficiaries need to understand the rules governing inherited retirement accounts.
Additionally, RMDs may increase the size of an individual's estate, which can have implications for estate taxes. Therefore, it is important to incorporate RMDs into a comprehensive estate plan.
Other strategies, such as making qualified charitable distributions (QCDs) or funding a charitable remainder unitrust (CRUT) or a charitable remainder annuity trust (CRAT), can be useful, but these are more specific and should be explored on a case-by-case basis.
It should be noted that those who inherit a Roth IRA are not subject to annual RMDs but still need to distribute the entire account balance by the end of the 10th year of the original owner's passing.
With proper planning, taking advantage of the delayed RMD requirements can save both you and your heirs a significant amount in taxes.
Conclusion
RMDs are an important part of retirement planning, and the recent changes will have significant implications for countless retirees and families.
Educating yourself on the various options is of the utmost importance and will help you and your heirs feel more comfortable that you have explored all the possible avenues. This isn’t the first time the rules have changed with respect to retirement accounts and surely won’t be the last …
Discuss your situation with our financial planning firm.
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