IRAs and 401 (k) s are great places to save money while working. They come with an input tax deduction for contributions, deferred income, and tax-free exchanges between mutual funds. Taxes are avoided for years, if not decades, while at work. Then, in retirement, the Minimum Payouts Required (RMDs) begin. It’s finally time to pay the piper.
Assuming you made all pre-tax contributions, RMDs are fully taxable at ordinary income rates. It’s a ticking tax time bomb.
A double tax rate on IRA withdrawals
Withdrawal taxes have two negative consequences. First, taxes can shrink your retirement account more than you expect. In order to withdraw $ 50,000 from a 401 (k) in Connecticut, a couple must deduct an additional $ 6,000 in federal taxes and $ 2,500 in state taxes. (Assume an income tax of 12% at the federal and 5% at the state level). This is especially worrying when the stock market crashes. There’s nothing worse than making a withdrawal and paying taxes when an account’s value has gone down.
IRA and 401 (k) withdrawals can also trigger a tax on your social security benefits. IRA and 401 (k) withdrawals count towards the calculation of “combined income” for Social Security. If the couple has a combined income of $ 32,000 to $ 44,000, up to 50% of the Social Security benefit may be taxable. If they combined $ 44,000, then up to 85% of their social security benefits are taxable (source: SSA.gov).
Withdrawals from traditional IRAs and 401 (k) s can also increase taxes on pensions or other income.
A strategy couples should consider to limit this tax burden
This is all a tax problem in the truest sense of the word. What to do? There are many opportunities. We call a strategy that we use with our customers “let the table run“That means the RMD table. This strategy starts a few years before retirement. First some background.
By the age of 72, IRA owners born on July 1, 1949 or later are required to make the required minimum distributions each year. There are three tables for calculating the minimum required distributions. Most people will be using the Uniform Lifetime Table. There are several interesting take-aways from the Uniform Lifetime Table. One is that as you get older, the division factor used to calculate the RMD gets smaller. This results in your RMD being a larger percentage of your balance. At the age of 72, the dropout rate is around 3.9%, at the age of 85 it is around 6.7%.
The key is to structure your accounts so that they are most beneficial to your RMDs. This idea works best for married couples a few years old. The older spouse – who is further down the RMD table – wants to direct more of their savings to accounts without RMDs compared to the younger spouse. Remember, the older the IRA owner, the higher the RMD withdrawal rate required. In this scenario, it is more beneficial for the older spouse to have more Roth IRA money than the younger spouse because Roth IRAs do not have RMDs and the distributions are tax free.
What this strategy might look like for a couple
For example, Jack and Jill each have IRAs of $ 500,000. Jack is 80 and Jill is 72. If both had pre-tax IRAs, Jack’s is RMD 26,737. Jill’s RMD is $ 19,531. However, if Jack had $ 250,000 pre-tax in a Roth IRA and $ 250,000 pre-tax in a traditional IRA, then his RMD will only be calculated on the $ 250,000 pre-tax IRA. No RMDs on the Roth. In this scenario, Jack’s RMD is only $ 13,368 instead of $ 26,000.
The moral of the story is, if couples want to play the RMD table in their favor, they should be careful early in life which of them is bringing in input tax money into a traditional IRA and which is into a Roth. For married couples with a slight age gap, it may be more beneficial to have more Roth money on behalf of the older spouse.
This is one of many strategies to minimize the tax burden on IRA withdrawals. The bigger realization that I hope readers understand is that planning ahead of time can create more and better options for your future self. Saving is important, but where you save also has an impact.
If you found this article helpful and are concerned about how taxes will affect your IRA, email me to learn more about our IRA tax audit, which includes running the table analysis and other IRA RMDs -Tax minimization strategies included. Email: email@example.com.
This article is written by our contributing advisor and represents the views, not the Kiplinger editors. You can review the advisor’s records with the SEC or FINRA.
CFP®, Summit Financial, LLC
Michael Aloi is a CERTIFIED FINANCIAL PLANNER ™ Practitioner and Accredited Wealth Management Advisor℠ at Summit Financial, LLC. With 17 years of experience, Michael specializes in working with executives, professionals and retirees. Since joining Summit Financial, LLC, Michael has built a process that emphasizes the integration of various facets of financial planning. Supported by a team of in-house inheritance and income tax specialists, Michael offers his clients coordinated solutions for individual problems.
Investment advice and financial planning are provided by Summit Financial, LLC, an SEC registered investment advisor, 4 Campus Drive, Parsippany, NJ 07054. 973-285-3600 Fax. 973-285-3666. This material is provided for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans in consultation with their independent tax or legal adviser. Individual investor portfolios must be constructed on the basis of the individual’s financial resources, investment objectives, risk tolerance, investment time horizon, tax situation and other relevant factors. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. The Summit financial planning design team has approved attorneys and / or auditors to act solely in a non-representative capacity with respect to Summit’s clients. Neither she nor Summit offer tax or legal advice to their clients. Any tax returns contained herein are not designed or written and cannot be used to avoid federal, state or local taxes.