Even after years of successful retirement planning you will still need to have a plan to avoid higher tax bills when taking distributions.
Although you may not necessarily need to take money out of your funded retirement accounts, the federal government requires you to start taking required minimum distributions (RMDs) once you turn 73 (recently raised from 72). Every dollar you take out of your non-Roth accounts is taxed as ordinary income, which can add up to a big tax bill for a well-funded retirement plan. You can also lose the tax-deferred growth on the money you have to withdraw. For this reason, it’s important to consider whether your RMDs will be more than your required living expenses.
Additionally, when social security benefits are included, you may be pushed into paying higher Medicare premiums. The income-related monthly adjustment amount, or IRMAA, is the fee you pay in addition to your Medicare Part B and Part D premiums if you make a yearly income above the annual thresholds. It applies to Medicare beneficiaries with a modified adjusted gross income above $97,000 ($103,000 in 2024) for an individual return and $194,000 ($206,000 in 2024) for a joint return.
So, what can you do to avoid higher tax liabilities associated with RMDs in retirement? We have put together a list of four possible steps to help lessen the pain when the time comes. As always, each option should be discussed with your financial advisor or accountant:
- Use Roth IRA conversions
- Develop a charitable giving strategy
- Decide on a distribution approach
- Consider a QLAC
Use Roth IRA conversions
A Roth conversion makes a good deal of sense a little earlier in your planning for a number of reasons. To start with, Roth IRAs don’t require RMDs. If you stay invested in a traditional IRA until age 73, your RMD may be higher than you need and will result in a larger tax liability. There are consequences of not paying taxes sooner. A conversion will help lower your liability as your IRA distribution combined with a Roth conversion could keep you in the same tax bracket.
Converting pre-tax retirement accounts such as IRAs and 401(k)s to after-tax Roth IRAs after age 60 can keep growing funds tax-free. You can then make withdrawals in retirement without paying taxes. In addition to not having to take an RMD, you can avoid early withdrawal penalties. Your money can stay in the account and keep growing tax-free.
Develop a charitable giving strategy
Are you charitably minded? Thankfully, charitably inclined individuals and couples age 70½ and older have a tax-smart strategy available to them. It’s called a qualified charitable distribution (QCD), also known as a charitable IRA rollover. Simply put, QCDs don’t need to be reported as taxable income. You won’t owe taxes on your QCD even if you don’t itemize deductions. Your adjusted gross income (AGI) may be reduced and therefore can impact calculations of the taxable portion of Social Security benefits.
So, with QCDs more of your assets can be used to support your favorite charities. You can instruct your IRA administrator to send up to $100,000 per year—all or part of the annual RMD—to one or more qualifying charities, excluding donor-advised funds. Married couples filing jointly can each qualify for annual QCDs of up to $100,000, for a potential total of $200,000. Starting in 2024, annual QCD limits will be indexed to inflation. In some cases, QCDs can provide greater tax savings than cash donations being claimed as charitable tax deductions.
Decide on a distribution approach
When doing your retirement cashflow analysis, make sure your RMD adequately provides what you need, not excessively more. In a traditional wisdom withdrawal approach, withdrawals are made from one account at a time, starting with Roth, then taxable and finally tax deferred accounts where taxable withdrawals are delayed the longest. By withdrawing from your traditional IRA last, you may accumulate balances so large that your RMD is above your income need.
Working with your financial advisor and accountant to create tax-optimized distribution strategy can maximize wealth and minimize lifetime taxes paid. This may result in using a proportional approach where you can withdraw from all accounts each year or a single account approach depending on current tax laws.
Consider a QLAC
Qualified longevity annuity contracts (QLACs) weren’t attractive when interest rates were low. In today’s higher interest rate environment, they are now worth looking into. A QLAC is an annuity product designed to prevent you from outliving your retirement savings. When you purchase a QLAC with funds from a traditional retirement account (401k or IRA), it’s deemed a qualified use by the Internal Revenue Service (IRS). That means you can deduct the amount of your QLAC purchase from the value of your retirement account balance, which is used to calculate your RMD.
It’s important to note here that the QLAC tax break is only temporary. The IRS requires you to begin taking RMDs from your QLAC no later than age 85, essentially providing an RMD tax break between the ages of 73 and 85. So, you are deferring RMDs and taxes, not permanently avoiding them. There are limits on how much one can contribute, but recent provisions in SECURE 2.0 did raise the maximum dollar amount to $200,000, adjusted for inflation each year.
Timing is critical. How and when you choose to withdraw from various accounts can impact your taxes in different ways. The goal is to allow tax-deferred assets the opportunity to grow over a longer period of time. By spreading out taxable income more evenly over retirement, you may also be able to potentially reduce the taxes you pay on Social Security benefits and the premiums you pay on Medicare. Please feel free to reach out to us with any questions you may have.
Thanks for reading.
This material has been provided for general, informational purposes only, represents only a summary of the topics discussed, and is not suitable for everyone. The information contained herein should not be construed as personalized investment advice or recommendations. Rather, they simply reflect the opinions and views of the author. D. B. Root & Company, LLC. does not provide legal, tax, or accounting advice. Before making decisions with legal, tax, or accounting ramifications, you should consult appropriate professionals for advice that is specific to your situation. There can be no assurance that any particular strategy or investment will prove profitable. This document contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information derived from such sources, and take no responsibility therefore. This document contains certain forward-looking statements signaled by words such as "anticipate," "expect", or "believe" that indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward-looking statements. As such, there is no guarantee that the expectations, beliefs, views and opinions expressed in this document will come to pass. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. All investment strategies have the potential for profit or loss. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The impact of the outbreak of COVID-19 on the economy is highly uncertain. Valuations and economic data may change more rapidly and significantly than under standard market conditions. COVID-19 has and will continue based on economic forecasts to have a material impact on the US and global economy for an unknown period.
Chief Planning Officer
Nancy I. Kunz
CFP®, CPFA®, ChFC®, CLU®