Be Careful: RMDs and Taxes Can Undermine Your Retirement Plans

Many Americans are in for a major shock when they reach their 70s. They’ve spent nearly their entire lives accumulating money and putting it in their 401(k)s and IRAs. But, when they reach their 70s, retirees face the dilemma of having to take required minimum distributions (RMDs) or else facing a significant tax penalty. Either way, these retirees may face a significant tax burden.

Too much tax deferral is like a pact with the devil. That sounds counterintuitive, especially as most accountants want to maximize your deductions and minimize your current tax liability. They don’t often think about how minimizing your taxes could cost you over the long haul.

A hypothetical example of the problem

As a hypothetical, let’s take a look at how Bob and Mary, a married couple, saved for their retirement. Following their accountant’s advice, Bob and Mary, who are in the 33% tax bracket, contributed $6,000 annually to their 401(k). By doing so, Bob and Mary saved $2,000 a year on their taxes for 35 years, a total of $70,000.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Now if Bob and Mary invested their money in a low-cost S&P 500 index fund over the last 35 years, let’s assume that they averaged 7.5% in their compound average return (this is for illustration purposes since, of course, the S&P 500 varies from year to year, unlike CDs and similar investments). Let’s say Bob and Mary’s money accumulates to $1 million. When they are forced to take RMDs out each year, if they withdraw at 7.5% – not the recommended withdrawal rate – they will be taking out $75,000, which is subject to income taxes. If Bob and Mary are in the same 33% tax bracket in retirement – and that is certainly possible – the total tax savings they got from their 401(k) contributions would be wiped away over the course of only three years.

How can this be? Aren’t people supposed to be in a lower tax bracket when they retire? Don’t count on it. In fact, the combination of pension income, Social Security and forced distributions from 401(k)s and IRAs can easily put a person back in the same tax bracket they were in when they were working and even, in some cases, a higher one.

Now Bob and Mary could decide not to take all the money out of their retirement accounts, leaving it to their children as a legacy. Right now, IRAs can be stretched over the lifetime of beneficiaries. But, as Ed Slott, a CPA, noted in Financial Planning magazine, there’s a push in Washington to end “stretch” IRAs and restore the original rule on inherited IRAs, which had a five-year payout on debt. With the national debt expected to exceed $20 trillion soon, the federal government could end stretch IRAs as it looks for new revenue.

All of this illustrates an overlooked problem that could undermine our retirement plans. All of us have a silent partner in our IRAs and retirement accounts by the name of Uncle Sam, whose share of the retirement accounts is the deferred income tax liability that accrues. Uncle Sam gets to change how much of your retirement accounts belongs to him by adjusting the tax rates. Even if President Trump gets his tax proposal passed, which would lower income taxes for some Americans, that does not mean that you will see lower tax rates when you take the bulk of your distributions. Simply put, not only do you have market risks, you also have political risks as you try to save for your retirement.

A few strategies to consider

Thankfully, there are some possible solutions to these kinds of challenges, including strategies you can employ to make sure taxes don’t sink your retirement plans.

• Insurance products. One good strategy would be to look at a custom-designed indexed life policy and universal life insurance policies where you can borrow money at extremely attractive interest rates, sometimes at 1% or less, to cover the tax liability. These policies may provide significant tax-free cash flow in retirement when properly designed. Of course, you should not do this on your own. You should consult with a licensed life insurance professional who works closely with qualified tax attorneys. This last part is important because, sadly, there are many insurance agents who will design life insurance policies to maximize commissions instead of maximizing benefits to the client.
• Roth conversions. Other tactics you can follow include making gradual conversions to your Roth IRAs. Of course, you need to have a Roth IRA for at least five years before you can take money out of it tax-free. A qualified tax adviser can work with you and your financial planner to identify how much you can convert each year without bumping yourself up into a higher tax bracket even because is income tax on the amount you are converting.
• Careful investing. Planning can also help alleviate these tax burdens. Retirement accounts start off as tax-friendly assets but can often wind up as tax-hostile ones. One strategy to consider is keeping your more conservative investments within your IRA and holding your portfolio’s growth-oriented investments outside your IRA. The investments outside your IRA are subject to a lower capital gates tax rate (usually 15% or 20%), while the ones in the IRA are subject to ordinary income tax rates, which are usually higher.

Increasingly, many Americans are frustrated when they reach their retirement because they are forced to take increasing required minimum distributions. Every year, as they move through their 70s and 80s, the percentage you are forced to take grows, and that can impact your taxes.

It’s important to work with a team of professionals on tax planning and distribution planning for retirement accounts. Keep that in mind securing your retirement is not just about investment planning and having the right asset allocation mix alone; it’s also about tax planning. There is no greater fee on a retirement account than taxation, and you need to plan accordingly.