Most Americans have money set aside for retirement in a 401(k) or IRA. If your money is in a qualified account, you are subject to RMDs, or required minimum distributions. The recent passing of the Secure Act has caused the rules around RMDs to change. Whether you want to have a plan for when RMDs start, or you want to avoid RMDs all together, you have options.
IRAs: RMDs and Tax-Free income
What are Required Minimum Distributions?
Qualified retirement accounts such as IRAs, 401(k)s, 457s, TSPs, 403(b)s, TSAs, SEPs, or SIMPLE IRAs require withdrawals in retirement. These withdrawals are required minimum distributions. The government requires withdrawals from these accounts because you have not paid taxes on the money in them; they are tax-deferred accounts. Uncle Sam is your silent partner in your retirement account and he will not go away until the taxes are paid, even in death.
RMD’s are calculated by using your age, life expectancy, and how much money you have in your accounts. They will be different for every single person. What if you decide you don’t want to take the money out? A very large penalty. The penalty for not taking a RMD, or not taking one large enough, is a 50% tax on the amount that was not withdrawn.
Many people start RMDs without a plan for how this is going to affect their income. Large withdrawals from your retirement accounts can cause everything from your Social Security check to be taxed to your prices for Medicare being raised due to IRMAA.
How the Secure Act Changed Retirement
The Secure Act, passed in December 2019, changed when RMDs have to be started. If you were born after July1, 1949, the Act moved the start age from 70 ½ to 72. For people born before July 1, 1949, the age remains 70 ½. By moving the date backwards, the government is giving people a small tax break since they can delay when they pay taxes on this money. In reality, it is not really a tax break because you are never going to get out of paying these taxes.
The Secure Act also got rid of the Stretch IRA. We won’t get too into it, but a Stretch IRA used to allow beneficiaries, who received a traditional IRA as an inheritance, to stretch out the RMDs over their lifetime instead of the deceased’s lifetime. Now, beneficiaries who are not spouses must drain these accounts in 10 years. Being able to stretch these distributions out allowed beneficiaries to less the tax bomb they receive, being able to pay these taxes slowly over their lifetime. Paying taxes over 10 years is going to significantly increase the taxes paid.
Don’t Use IRAs for Estate Planning!
We had a brother and sister, Jackson and Sybil, who lost their mother Edith. Edith kept the majority of her money in her retirement account thinking it would be easy to leave to her children when she passed. There was a sizable amount in the account, about $800,000, so each child got $400,000. The issue that both children ran into is that this money was in a traditional IRA, meaning they had to pay taxes on the money. Jackson took his half in a lump sum, losing almost half of it to taxes. Sybil did a Stretch IRA and spread the distributions over her lifetime. She is getting a check every year and is paying taxes bit by bit at a lower tax rate.
If Edith had planned ahead, she could have put into place strategies to make this money tax free for her children, leaving them with less of a burden. IRA money is not meant for estate planning, it is meant for living off in retirement. If you do not need all the money you have in your accounts, it is time to find a better place to keep it.
Making Retirement Income Tax Free
The best strategy with retirement income and RMDs is going to be to reduce your taxable income before retirement so you do not have to worry about it. One of the most common strategies we see our clients use is converting all their traditional IRAs and 401(k)s into tax-free Roths. As we mentioned earlier, Traditional IRAs use pre-tax money. Roth IRAs use post-tax money, meaning the money you put into these accounts is already taxed. For this reason, RMDs do not apply to Roths and when you take the money out of these accounts, it does not have to be reported as income. Roth conversion does involve paying off Uncle Sam now, but you can buy him out while tax rates are still low.
Another part of this strategy involves building up substantial cash value in a life insurance policy, which will be available tax free in retirement. This can get complicated, but to summarize, you can put money into a life insurance product that also allows for loans from the policy that can give you cash when you need it.
While both Roth conversion and life insurance will make sure you have a low taxable income in retirement, it will also make sure the money you leave to your heirs will be easily accessible as well as tax free. This is such a gift for family members to receive in a time of need. Making retirement income tax-free can be a lucrative, but complicated, process. Make sure you don’t attempt it on your own; you could run into a huge tax bomb. Cardinal can help you navigate this process.