Taxes in Retirement

in Retirement Planning by

Most Americans stop celebrating “half birthdays” back in grade school. The two most important birthdays in financial planning, however, are half birthdays long past that age: 59½ and 70½.  Reach the first, and the IRS give you a gift: penalty-free withdrawals from your IRAs and 401k’s.  Reach the second, and the IRS give you another: Required Minimum Distributions (RMDs). This gift, however, may not be the pretty package it seems at first. Many fear these forced distributions will increase their tax rate over time. Is this true?  We crunched the numbers, and it turns out that in many cases, there’s nothing to worry about.

What Are RMDs?
RMDs are an annual amount people are required to withdraw from their tax-deferred accounts when they are older than 70. The most common of these are traditional 401ks and IRAs. The government incentivizes people to save for retirement by providing tax deferral in these accounts; however it doesn’t want this deferral to last forever, so it requires us to take out money, starting in the year we turn 70 ½. The required withdrawal amount is a percentage of the account, and increases with age, starting at about 3.5% at age 70:

RMD graph

As with any funds withdrawn from tax-deferred accounts, RMDs are considered taxable income, so withdrawing these funds will increase the income reported on your tax return. There’s the fear that RMDs will increase your income so much, you will be in a higher tax bracket, and must pay higher taxes as a percentage of that income.

The 10%+ of your IRA balances added to your income in later years seems daunting, but there are actually two factors mitigating the impact of this increase. First, the required annual distributions hinder the growth of the account value, so that it does not balloon over time. By taking your RMD in one year, you are decreasing the account balance relative to what it would have been if you didn’t take one. The effect is small year-to-year, but compounds significantly over time.

Second, and just as important, tax brackets increase with inflation over time. Combined, these factors mean that the tax impact of increased RMD percentages later in life have less of an impact than you might think.

RMD and Inflation Example
Suppose you are 70 years old, married filing jointly, with $1 million in your tax-deferred IRA. You have other income including Social Security at about $30,000 per year. Your $1 million IRA has 5.5% annual growth and 2.5% annual inflation. Let’s say you withdrew the RMD amount each year from the IRA but nothing more. Graphed below is the trajectory of RMDs over time, both in nominal (face value) and real (inflation-adjusted) amounts:

RMD inflation

In nominal terms, RMDs start out at about $36,000 and peak at almost triple that amount, around $93,000. However, once adjusted for inflation, the peak is at about $53,000.

This means that even at the peak RMD year, your adjusted gross income (AGI) would be about $85,000. After exemptions and deductions, your taxable income would likely be well below $75,000 per year. In this case, you would remain in the 15% federal income tax bracket; your RMDs would not have moved you into a different tax bracket. In the cases where they do put you in the 25% tax bracket, it is rare that this is a tax bracket increase from when you were working. Put another way, most people’s tax bracket decrease in retirement, and RMDs usually do not change this. As a general rule of thumb, RMDs are not too worrisome until the value of tax-deferred assets is around $1.5 million or more.

Strategies around RMDs

RMDs do not have to be spent. They are required to be withdrawn from tax-deferred accounts, but if you don’t need to spend the money, it makes a lot of sense to simply transfer it to your taxable brokerage account and invest it there.

If RMDs will likely increase your income tax bracket in retirement, then there are ways to decrease them if you plan ahead. The main way to do this is to withdraw money from your tax-deferred accounts when you are in a low-income year. Often a sweet spot to do so is between retirement and either age 70 or the year you start taking Social Security benefits. For example, doing a Roth conversion could make sense if it doesn’t increase the current tax bracket but would decrease a future tax bracket by decreasing the RMD amount. This is the type of calculation we do for many of our clients who are near retirement or recently retired.

If you give to charity, you also might want to consider using your RMD distribution to gift. The amount you gift can help reduce your tax bracket. It can be a better strategy to use your RMD requirement versus giving cash from your after-tax savings. Make sure to consult with your tax adviser before implementing this type of strategy.

RMDs can be worrisome at first glance, but as the numbers show, they’re not that bad. So channel your inner child and start looking forward to those half birthdays once again.

Still have questions about how to handle these? Schedule a free consultation with us today!

The following two tabs change content below.
Zach Lott, CFP®

Zach Lott, CFP®

Zach Lott is a Research Associate on the Portfolio Management team at Personal Capital. He trades client accounts on a daily basis and helps develop internal financial planning tools. He graduated with a degree in economics from Stanford University.
Zach Lott, CFP®

Latest posts by Zach Lott, CFP® (see all)


3 comments

  1. Jack

    Zach, I am in my second year of RMDs and have taxes withheld from my (monthly) disbursals, which eliminates the need for quarterly tax payments.
    Since my IRA is invested in dividend growth stocks, the generated dividends are covering the RMD – and based on my projections – will do so for the next 10 years at least – with no need for selling stocks.
    Of course, the RMD is calculated based on year-end market value, so projecting future RMDs is anything but scientific, but my projections of dividends and dividend growth are cost-based, and perhaps more realistic.

    Reply
  2. Howard

    Zach- You are forgetting that RMDs also have the potential of raising your Medicare part B and Drug plan costs which are based on adjusted gross income.

    Reply
  3. Alan Farrar

    Do you have a strategy for converting IRA accounts to ROTH that would save overall taxes and allow more tax free growth

    Reply

Leave a Reply

Your email address will not be published.

Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.