• Marcus P. Miller, CFP®

Required Minimum Distributions (RMDs)

Everyone who enters retirement with a traditional retirement account will confront RMDs. The SECURE act of 2019 made changes to Required Minimum Distributions. Consider this article your crash course before retirement.


The RMD is a way for the government to ensure they tax all of your income. As we earn throughout our working lives, we have the ability to save in a tax-deferred retirement account. This “traditional” account removes the tax liability in the year it was earned, and instead assigns the tax liability to the year the owner withdraws it from the account. In the withdrawal year it is taxed as “income”.


The RMD places a clock on the traditional retirement account, requiring a portion of the account to be withdrawn each year. The portion increases each year as you age beyond the initial ‘start age’ of 72.


Note: If you were 70.5 years old by January 1, 2020, then your RMDs started at 70.5.


Example

Imagine a working-age person, let’s call her Beth. Beth works until she is 65, saving diligently in her traditional IRA and 401k. Upon retirement at 65 there is no RMD, so she is free to withdraw as much or as little as she likes. Every dollar that she withdraws from the accounts is considered taxable income, so she must be careful not to withdraw too much, or she may find herself paying 30-40% tax rates.


When Beth turns 72, she will be required to withdraw a minimum amount from her retirement account(s) due to RMD’s starting. The IRS believes that she will live another 27.4 years (using current tables). Beth will add up all of her traditional retirement accounts on December 31st of the prior year, and divide by 27.4. The result is her Required Minimum Distribution for the year she turned 72.


The RMDs for Beth may end up being less than she was intending to withdraw already. If that is the case, then the RMDs are not a concern this year. Each year the amount of money in the accounts and the number of years to divide by will change. For example, when Beth turns 85 she will divide her account balance by just 16.


Imagine Beth retired at 65 with $2 million dollars. She withdraws $80,000 per year, in addition to her Social Security and other income. Each year her retirement account earns $80,000 in interest and dividends (lucky her!). At 72, Beth still has $2 million in her traditional retirement account and is planning to withdraw $80,000 again this year. The RMD calculation requires her to take a minimum of $72,992, so it does not affect her this year. However, the year Beth turns 75 the RMD calculation would require her to withdraw $81,300. If she is not aware of this, the IRS applies a 50% tax to any amounts not withdrawn. This means that she will owe an additional $650 in taxes if she does not withdraw the extra $1,300 required by RMDs. Assuming that her account remains at $2 million dollars, at age 85, the RMD will be $125,000.


The effect of RMDs compounds as retirees age. Some older retirees are required to withdraw 10% or more of their portfolios year after year. The result is often a family being pushed into very high tax brackets during their retirement years.


A secondary impact of RMDs is possibly pushing a family into higher brackets, resulting in additional tax on their Social Security and higher Medicare premiums (called IRMAA). These should be reviewed to determine if there are additional benefits to aggressive tax planning.


When do I have to withdraw?

As you approach the RMD age, you may be wondering when you actually need to withdraw the money. Technically, you can withdraw your first RMD by April 1st of the year after you turn 72. Then, by December 31st of every year after. However, if you choose to withdraw in January-March the year after you turn 72, you will have to withdraw two times in that year, possibly raising your tax bracket! Consider withdrawing your first RMD in the year you turn 72 to avoid taking two RMDs the following year.



Tax Planning

The solution to RMDs, and their possible tax implications, is tax planning. This involves looking at the expected withdrawal rates in the future, including RMDs, and projecting what tax bracket you will be in. Then, determine if there are any years when you will be in a lower tax bracket.


Using Beth’s situation, we can determine in which years she is in a lower tax bracket. For simplicity, we will assume she is a single filer for tax purposes and will not include any other income (SS, pension, etc). From ages 65 to 74 she will take only $80,000 per year, with RMDs requiring her to increase her withdrawals starting at 75.


Beth’s income of $80k places her in the 22% tax bracket, but as RMDs kick in she will be forced to withdraw more, pushing up into the 24% and 32% tax brackets. This is because her withdrawals, and thus “income”, will rise from $80,000 to over $250,000 (if she lives that long).


So how does Beth avoid the higher tax brackets?


Roth Conversions

A Roth conversion is the process of moving money from a traditional retirement account into a Roth retirement account. By doing a Roth conversion, you are claiming “income” and paying the tax this year.


Beth can choose to convert up to the 22% bracket cap each year, and later use this money during retirement without the worry of tax.


The 22% tax bracket is capped at $89,075 for single filers in 2022. Her withdrawals of $80,000 allow her to do a Roth conversion each year of $9,075 and pay just 22%. By maxing the 22% bracket each year, she will convert $90,750 and pay $19,965 in tax over 10 years.


Alternatively, if she chose to wait and allow the RMDs to mandate the withdrawal, she may end up withdrawing in the 35% tax bracket. The same $90,750 at 35% tax would be $31,762.50, making the Roth conversions a tax savings of $11,797.50.


Each person is different, with single, married, and head of household filers claiming different tax brackets. Additionally, the starting balance of your accounts, retirement age, social security amount, and other tax implications all affect the Roth conversion decision.


QCDs

When RMDs start you are required to withdraw the money. What if instead of withdrawing to your checking account, you decided to write a check to your favorite charity? This is called a Qualified Charitable Distribution (QCD) and is a way to donate before-tax dollars while simultaneously meeting your RMD requirement.


The process requires that you get a checkbook or debit card for the traditional retirement account and use it only for charitable purposes. Then at the end of the year, you will inform your accountant for tax purposes. Do not use this process for small items or you will end up paying your accountant more than you are saving on taxes.


If you are charitably inclined, a Qualified Charitable Distribution may be a way for you to solve for RMDs. The concept is to donate the RMD amount directly from your traditional IRA. This does not produce a tax benefit over the amount you are gifting, so this strategy only works if you were already going to give to charity.


Summary

If you’re like most people, you’ve never heard or thought of RMDs, Roth conversions, or QCDs until today. The concept of moving money around to change your tax bill may seem trivial. However, many families see tens of thousands of dollars in savings in their tax bills over a 10-15 year period. Executing the above strategies can get complicated, so don’t hesitate to contact your trusted CERTIFIED FINANCIAL PLANNER or CPA.