IRA Tax Planning: Minimizing the RMD Ticking Time Bomb

IRAs and 401(k)s are great places to save while working. They come with an upfront tax deduction for contributions, tax-deferred earnings and tax-free exchanges between mutual funds. Taxes are avoided for years, if not decades, while working. Then, in retirement, required minimum distributions (RMDs) start. It’s finally time to pay the piper.

Assuming you made all pretax contributions, RMDs are fully taxable at ordinary income rates. This is a ticking tax time bomb.

A Double Tax Hit on IRA Withdrawals

Taxes on withdrawals have two negative consequences. First, taxes can shrink your retirement account more than you anticipate. If a married couple in Connecticut want to withdraw $50,000 from a 401(k), they must take out an additional $6,000 in federal taxes and $2,500 in state taxes. (Assuming a 12% federal and 5% state income tax). This is especially worrisome when the stock market crashes. There is nothing worse than taking a withdrawal and paying taxes when an account value is down.

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IRA and 401(k) withdrawals can also trigger a tax on your Social Security benefits. IRA and 401(k) withdrawals count toward the “combined income” calculation for Social Security. If a married couple have a combined income of $32,000-$44,000, then up to 50% of the Social Security benefit may be taxable. If they have more than $44,000 of combined income, then up to 85% of their Social Security benefit is taxable (Source: SSA.gov).

Withdrawals from traditional IRAs and 401(k)s can also increase the taxes due on pensions or other income.

One Strategy for Couples to Consider to Limit This Tax Hit

This is all quite literally a taxing problem. What to do? There are many options. One strategy we use with our clients is what we call “running the table,” the RMD table, that is. This strategy begins several years before retirement. First some background.

At age 72, IRA owners born on July 1, 1949, or later need to start taking required minimum distributions each year. There are three tables to calculate required minimum distributions. Most people will use the Uniform Lifetime Table. There are several interesting take-aways from the Uniform Lifetime Table. One is that as you get older, the dividing factor to calculate the RMD gets smaller. This causes your RMD to be a greater percentage of your account balance. At age 72 the withdrawal rate is about 3.9%, but at age 85 the rate is roughly 6.7%.

The key is to structure your accounts in a way that is most advantageous for your RMDs. This idea works best for married couples a few years apart in age. The older spouse – who is further along the RMD table – would want to channel more of his or her savings into accounts that don’t have RMDs, compared with the younger spouse. Remember, the older the IRA owner, the higher the RMD required withdrawal rate. In this scenario, it is more advantageous for the older spouse to have more Roth IRA money than the younger spouse since Roth IRAs have no RMDs and the distributions are tax-free.

How This Strategy Could Look for One Couple

For example, Jack and Jill each have IRAs of $500,000. Jack is 80 and Jill is 72. If both had pretax IRAs, Jack’s RMD is $26,737. Jill’s RMD is $19,531. However, if Jack had $250,000 in a Roth IRA and $250,000 in a pretax traditional IRA, then his RMD is only calculated on the $250,000 pretax IRA. No RMDs on the Roth. In this scenario, Jack’s RMD is only $13,368 instead of the $26K.

The moral of the story is, if couples want to play the RMD table in their favor, they should pay attention early on in life which of them contributes pretax money into a traditional IRA and which contributes to a Roth. For married couples slightly years apart in age, it may be more advantageous to have more Roth money in the older spouse’s name.

This is one strategy of many to minimize the tax burden on IRA withdrawals. The bigger takeaway I hope readers understand is planning early can create more and better options for your future self. Saving is important, but where you save has equally long-lasting implications.

If you found this article helpful and are concerned how taxes will impact your IRA, email me to learn more about our IRA Tax Review, which includes the “running the table” analysis and other IRA RMD tax minimization strategies. Email: maloi@sfr1.com.