I’ve spent the past 30 years shoveling money into my 401(k). Now, semi-retired at age 63, it’s time to start shoveling it out. But here’s the challenge: How much money can I shovel out of this and other tax-deferred accounts I have during the next nine years while avoiding a killer tax bill?
Having a lot of money in a 401(k) or traditional individual retirement account often creates tax headaches in retirement. That’s because, at age 72, the law requires that most people begin taking required minimum distributions, or RMDs, from these tax-deferred accounts. (The age for RMDs was recently increased from 70½ as part of the Secure Act.)
Combined with Social Security payments and other income, these mandatory distributions frequently shove seniors into higher tax brackets. Ouch! By raising their taxable income, the RMDs can also raise the amount of money they have to pay for Medicare. Double ouch!
The conventional wisdom is that retirees should empty their taxable accounts before touching tax-deferred accounts and finally Roth IRAs where their money is growing tax-free. That approach has its merits. But it can result in retirees paying almost no taxes in their first years and then hitting a “tax bump” when they begin receiving Social Security and are forced to take distributions from their tax-deferred accounts.
“We often find that standard advice, ‘Defer, defer, defer,’ knocks you up a bracket when RMDs kick in,” says Joel Hardin, a retirement planner in Troy, Mich.
One solution to this conundrum is converting pre-tax dollars—such as those in 401(k)s and traditional IRAs—to after-tax dollars in Roth IRAs early in retirement while your tax rate is low.
To be sure, not all retirees are focused on minimizing taxes. Consider a parent who wants to leave money to a high-earning adult child. The child may be in a much higher tax bracket than his retired parent. Thus, the parent might opt to pay more taxes now so that he can pass money not subject to taxation to his child. The parent could decide to live off money in his 401(k) or traditional IRA, paying the necessary taxes, and leave after-tax money for his child.
Other retirees want to leave much of their wealth to charity. If they take their RMD as a qualified charitable distribution, it won’t trigger higher taxes or higher future Medicare premiums. To do so, you direct the administrator of your tax-deferred account to make a donation directly to the charity, and it won’t show up as taxable income.
“This is a pretty complicated problem when you try to solve it fully,” says Andrey Lyalko, a vice president for financial solutions at Fidelity. He says retirees should have clear goals on their spending and estate planning to figure out the right distribution strategy.
Seniors should begin thinking about the impact of RMDs early in retirement, or even before they stop working. Once they’ve begun making RMDs, they have much less flexibility to avoid higher taxes.
The required minimum distributions for an IRA begin at 3.91% for a 72-year-old and rise each year. By age 90, the current RMD is 8.77%, meaning a retiree with $2 million remaining in an IRA at that point must withdraw $175,400 from it.
William Reichenstein, a Baylor University finance professor emeritus who is head of research at Retiree Inc., knows a retired couple in their late 60s with $4.4 million in financial assets, including $3.5 million in tax-deferred accounts. The couple are making substantial Roth conversions each year to reduce their tax-deferred accounts. Otherwise, they will end up paying higher taxes in the future because of RMDs, plus paying higher Medicare premiums.
The tax and Medicare premium woes from RMDs often get worse when one spouse dies. The surviving spouse must still make RMDs but is usually in higher brackets both for taxes and Medicare premiums as a single person.
There was nothing for me to do last year as I worked full time for more than half of 2019, and any distributions from my IRA would have been taxed at a higher rate as a consequence.
This year is a different story. My wife and I are living off money from after-tax brokerage accounts plus the money I earn from freelancing articles like this one. Our top rate as a married couple with the standard deduction will be just 12% up to almost $105,000 in adjusted gross income. If I earn $50,000 in part-time work and investment income, that means I can take an additional $55,000 from my IRA and convert it to a Roth IRA at the 12% tax rate or lower.
If I do this every year until I turn 72, I will have a smaller IRA that will trigger smaller RMDs. The only complication will come at age 70 when I plan to start collecting Social Security. If I keep working then, the additional income will push me into a higher tax bracket. If I stop working, I will still be able to convert some IRA money to a Roth IRA and stay in the same tax bracket.
Any money I put in the Roth IRA, meanwhile, will grow tax-free and has no required distributions. I can spend it whenever I want to or leave it to my children.
The downside: It’s a good bit more complicated than simply spending from one account. Every year-end, I will have to tally up my earnings and investment income, and figure out how big a Roth IRA conversion I can make without pushing myself into a higher bracket.
This is the same exercise financial planners should go through for their clients.
“We think about the brackets, and where you fall in the brackets, and filling out those brackets,” says Julie Virta, a senior financial advisor at Vanguard.
Ultimately, this is one of the few situations where paying taxes now will actually save me money in the long run. IRS, here I come.
Want to read another article from cwgadvisors.com. Visit the following article to learn more about the decade in retirement:
The Decade in Retirement