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Navigating the inevitable tax bite of required minimum distributions (RMDs)

by Alliance America
February 19, 2024


Required minimum distributions (RMDs) refer to mandatory annual withdrawals retirement account owners must take starting at age 73. The concept behind RMDs stems from rules stating retirement savings vehicles like 401(k)s and IRAs receive beneficial tax advantages meant to incentivize saving for retirement – not indefinitely preserving wealth tax-free.

Specifically, traditional 401(k) and IRA contributions use pre-tax dollars. This reduces your taxable income the year money goes into these accounts. Also, earnings growth in the accounts happens tax-deferred. However, the government expects to eventually recapture some tax dollars on this pile of untaxed money to finance public services.

RMD rules require retirees to start withdrawing a percentage of account balances dictated by Internal Revenue Service (IRS) life expectancy tables. This percentage climbs each year based on reducing expected remaining years of life. RMD income gets taxed as ordinary income. So the annual RMD serves as the carrot-and-stick mechanism permitting retirement account tax perks earlier in exchange for repaying some tax dollars later to the government.

If you fail to take RMDs after age 73, penalties of up to 50% of the RMD amount apply. Beyond taxes owed, this makes RMDs an unavoidable aspect of retirement income planning.

RMD rules fundamentally uphold the original purpose of retirement accounts funding retirement. Withholding taxes indefinitely deprives taxpayers funding public services. RMDs provide a standardized, systematic framework for distributing tax-advantaged savings gradually during retirement years as intended when establishing retirement incentives.

Who must take RMDs?

elderly man holding a calendar

Required minimum distributions (RMDs) must be taken by individuals who own certain types of retirement accounts once they reach a specific age. The starting age for RMDs was raised to 73 effective in 2023. The rules for who must take RMDs include:

  • Owners of traditional IRAs. Individuals who have traditional individual retirement accounts (IRAs) are required to start taking RMDs. This rule also applies to SEP IRAs and SIMPLE IRAs.

  • Owners of 401(k)s and other employer-sponsored plans. Participants in employer-sponsored retirement plans, such as 401(k), 403(b) and 457 plans, are generally required to take RMDs. This includes those who are still working, depending on the plan's rules and the individual's ownership status in the company.

  • Roth IRAs. Unlike other types of retirement accounts, Roth IRAs do not require RMDs during the account owner's lifetime.

It's important to note that failing to take RMDs, or taking less than the required amount, can result in significant tax penalties. Therefore, it's crucial for individuals who fall into these categories to understand their RMD requirements and comply accordingly. Additionally, tax laws and regulations are subject to change, so staying informed about current rules or consulting with a financial professional is advisable.

How do RMDs get calculated?

The Internal Revenue Service provides uniform lifecycle tables that determine what percentage of retirement account balances must get withdrawn each year as an RMD after age 73. These tables factor in account balances and one's age to set the minimum distribution levels.

In general, the RMD withdrawal percentage escalates annually as an individual ages, under the assumption that remaining life expectancy declines each year in retirement. So the older a retiree gets, the larger the percentage of retirement savings they must withdraw for that year.

For example, at age 73 the uniform table states an account owner must withdraw 3.8% of total balances as their RMD. If they have $500,000 across retirement accounts at age 73, they must take out $19,000 for that year (3.8% of $500,000). By age 80, the required withdrawal percentage jumps to 5.9%, meaning on that same $500,000 they would need to take $29,500 as their RMD at age 80.

The dollar amount scale up over time because the cumulative percentage withdrawn is intended to empty accounts by one's projected lifespan per IRS data. So annual RMD percentages accelerate downward drawdowns of retirement money.

In practice, real-world returns impacting growing or shrinking principal balances also alter actual RMD amounts owed. But the uniformly increasing IRS percentages on total balances drive most escalation of RMD cash outlays each year in retirement.

What are the tax implications of RMDs?

jar of money labeled taxes

The tax implications of required minimum distributions from retirement accounts are an important consideration for retirees. Understanding how these distributions are taxed and what strategies can be employed to minimize the tax burden is crucial for effective financial planning.

RMDs are typically taxed as ordinary income. This means the amount withdrawn is added to your other income for the year and taxed at your applicable income tax rate.

Unlike certain types of investment income that may qualify for lower capital gains tax rates, RMDs do not receive any special tax treatment. They are taxed at the same rate as your salary or wages.

Federal income tax may be withheld from your RMDs. If the withholding is not sufficient to cover the tax liability, you may need to make estimated tax payments to avoid penalties. While RMDs are a mandatory aspect of many retirement accounts and are taxed as ordinary income, there are strategies that can be employed to manage and potentially reduce the tax burden associated with these distributions. These strategies include:

  • Timely withdrawals. Ensure that you take RMDs on time to avoid the hefty 50% excise tax on the amount that should have been withdrawn.

  • Spread out the tax liability. If you retire before the required beginning date for RMDs, consider taking distributions over several years to spread out the tax liability, especially if you expect to be in a lower tax bracket in the initial years of retirement.

  • Charitable contributions. If you are charitably inclined, consider using a qualified charitable distribution (QCD). A QCD allows individuals over the age of 70½ to donate up to $100,000 directly from their IRA to a qualified charity. This amount can count toward your RMD and will not be included in your taxable income.

  • Roth conversions. Converting funds from a traditional IRA to a Roth IRA can be a strategic move. While the conversion amount is taxable in the year of the conversion, it reduces future RMDs and the associated tax liability since Roth IRAs do not have RMDs during the owner's lifetime.

  • Tax diversification. Having a mix of taxable, tax-deferred and tax-free accounts can provide more flexibility in managing taxable income in retirement. Withdrawals from these different account types can be strategically planned to minimize overall tax liability.

  • Consider state taxes. Be aware of state taxes on RMDs. Some states do not tax retirement income or offer exemptions and deductions that can reduce your state tax burden.

  • Investment choices within tax-deferred accounts. The type of investment held in tax-deferred accounts doesn't impact the tax treatment of RMDs, but smart investment choices can impact overall retirement income and tax liability.

  • Professional advice. Consult with financial professional. Tax laws are complex and subject to change, and a professional can provide personalized advice based on your specific financial situation.

What is the impact of market fluctuations on RMDs?

Required minimum distributions can prove painfully ill-timed when markets decline and portfolios contract during economic downturns. Since RMD percentages apply to overall account balances, market corrections shrinking those values consequently reduce the dollar amounts owed for distributions.

However, with the account containing fewer assets after drops, those fixed distribution rates withdraw a larger proportional share of available retirement savings exactly when less can be afforded. This heightens the sequence of returns risk – the danger of suffering losses in crucial early retirement years from which portfolios struggle to recover. Employing savvy asset management and withdrawal strategies carries vital importance for mitigating the amplified sting of compulsory distributions amid market and economic volatility.

Primarily, retirees should prioritize retaining higher percentages of equities, rather than shifting heavily toward bonds and cash, in the front end of retirement even amid rocky markets. As riskier yet higher-growth assets, equities stand the best chance of recovering losses over lengthy investment horizons still available early in retirement. This avoids locking in losses permanently by selling depressed equity shares. Concurrently, delaying the start of Social Security until age 70 ensures bigger inflation-protected lifetime income payments will compound later as a counterbalance during troubled markets earlier.

Keeping one to two years of living expenses in reserve cash also allows entirely pausing portfolio withdrawals to skip sold-at-a-loss RMDs for periods when able. For ultimately smoothing the effects of fluctuating markets and RMDs, diversifying income sources beyond just savings also helps mitigate reliance on vulnerable stock and bond holdings. Annuities, CD ladders, rental income or other uncorrelated revenue streams enhance retirement staying power. With the right foundations and frameworks in place, the wrenching impacts of economic and market gyrations drag less severely on long-term retirement solvency.

How does retiring early or working beyond retirement age impact RMDs?

sticky note labeled retirement on top of money

For those able to retire substantially before age 73, years of potential tax-deferred investment compounding get cut short well before RMDs commence. Losing even five to seven years of tax-deferred growth considerably reduces ultimate balances subject to mandatory distributions later. The tradeoff secures additional untaxed growth upfront while allowing Roth savings to further appreciate before tapping any taxable distributions.

Individuals continuing workplace activity beyond the standard RMD start age of 73 do gain leeway to delay distributions from current employer 401(k) plans until actually separating from those jobs. This stretches tax-deferral further while accumulating greater balances to counteract later higher RMD rates in advanced age. However, for IRA holdings or inactive company plans, RMDs still generally must begin at 73 regardless of working status. So tracking parallel deadlines remains imperative.

In essence, exercising full control over exiting the workforce on your own terms allows some flexibility in managing the tax implications of work-based savings. But across the spectrum of retirement timelines, taxpayers lose significant leverage once reaching age 73. Strategic Roth conversions, aggressive savings rates and properly sequencing taxable income realize maximum advantage no matter if retiring early, on-time or later with RMDs continually looming.

How can insurance products reduce the impact of RMDs on my portfolio’s longevity?

Some retirement products, like deferred income annuities, can help address problems posed by required minimum distributions (RMDs). Annuities provide guaranteed future income. This could help people avoid running out of savings in later years.

Annuities allow people to convert some retirement savings into monthly payments for life. These payments start at older ages like 80 or 85. This gives retirees money every month that an insurance company is responsible for. It doesn't rely on savings accounts lasting on their own through a person's whole life.

This pairs well with larger RMD withdrawals kicking in at older ages, too. The steady checks from the annuity reduce dependence on savings balances to fund spending. This provides a cushion if investments drop in value. Since guaranteed money comes from the annuity now, savings face less risk even if stock markets struggle.

Annuities shouldn't replace savings fully though. Their main role is balancing risks. They provide peace of mind by covering basics if someone lives longer than expected. Annuities also guard against savings falling faster than predicted. Starting annuity payments before big RMD impacts start makes coordinating both income sources simpler over time too.

The big drawback is losing flexibility and access to the money used to purchase the annuity. So balancing guarantees while keeping some liquid savings available remains key. But when used thoughtfully within complete retirement strategies, certain annuities help offset scenarios where late-in-life RMDs overwhelm retirement investment accounts down the road.

Alliance America can help

Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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