Chapter 20
RMDs: The ugly surprise at the end
of the tax-deferred rainbow
Someday, if all goes well, you’ll wake up to find you’ve reached the ripe old age of 70 1/2. Hopefully in good health, you’ll rise from bed, stretch and greet the new day happy to be alive. You’ve worked hard, saved and invested, and now are contentedly wealthy and secure. Since you’ve diligently maxed out your tax-advantaged accounts, much of that wealth might well be in those, tax-deferred for all these years. On this day, if you haven’t already, you’ll begin to fully appreciate the “deferred” part of that phrase. Because your Uncle Sam is waiting for his cut and he figures he’s waited long enough.
Except for the Roth IRA, all of the tax-advantaged buckets discussed in Chapter 19 have RMDs (required minimum distributions) as part of the deal and these begin at age 70 1/2. Basically this is the Feds saying “OK. We’ve been patient but now, pay us our money!” Fair enough. But for the readers of this book who are building wealth over the decades, there may well be a very large amount of money in these accounts when the time comes. Pulling it out in the required amounts on the government time schedule could easily push us into the very highest tax brackets.
Make no mistake, once you reach 70 1/2 these withdrawals from your IRAs, 401(k)s, 403(b)s and the like are no longer optional. Fail to take your full distribution and you’ll be hit with a 50% penalty. Fail to withdraw enough and the government will take 50% of however much your shortfall is. That’s right, they will take half of your money. This is not something you want to overlook.
The good news is that if you hold your accounts with a company like Vanguard, they will make setting up and taking these distributions easy and automatic, if not painless. They will calculate the correct amount and transfer it to your bank, money market, taxable fund or just about anyplace else you choose and on the schedule you choose. Just be sure to get the full RMD required each year out of the tax-advantaged account on time.
Just how bad a hit will this be? Well, there are any number of calculators online that allow you to plug in your exact numbers for an accurate read of your situation. Vanguard has their own, but so do companies like Fidelity and T. Rowe Price. To give you an idea of what the damage might look like, I plugged into Fidelity’s to provide the following example.
You’ll be asked your birth date, the amount of money in your account as of a certain date (12/31/13 when I did it) and to select an estimated rate of return. I chose January 1, 1945, $1,000,000 and 8%. No, those are not my real numbers. In a flash the calculator gave me the results year by year.
Here’s a sample:
Year RMD Age Balance
2015 $39,416 70 $1,127,000
2020 $57,611 75 $1,367,000
2025 $82,836 80 $1,590,000
2030 $116,271 85 $1,742,000 2035 $154,719 90 $1,750,000
The good news is that even with these substantial withdrawals, the total value of our account will continue to grow. But, as we’ve discussed before, these are estimated projections. The market might do better or worse than 8% and it most certainly won’t deliver 8% reliably each year on schedule.
The bad news is, not only do we have to pay tax on these withdrawals, the amounts could push us into a higher tax bracket. Or two. This, of course, will depend on how much income you have rolling in from your other investments, Social Security, pensions and the like.
To give you a frame of reference, here are the tax brackets for those married and filing jointly in 2016:
0 to $18,550—10%
$18,551 to $75,300—15%
$75,301 to $151,900—25%
$151,901 to $231,450—28%
$231,451 to $413,350—33%
$413,351 to $466,950—35% $466,951 or more—39.6%
Based on this, we can see that even with no other income, by age 90 our taxpayer’s RMD of $154,719 will put them in the 28% tax bracket even without considering any other income. And that’s based on starting with only $1,000,000. Many readers applying the principles in this book starting in their 20s, 30s and 40s can easily expect to have several multiples of that by the time they reach 70 1/2.
Something that is important to note here—which confuses many people —is that this doesn’t mean they pay 28% of the full $154,719 in taxes.
Rather they pay 28% only on the amount over the $151,900 threshold of the bracket. The rest is taxed at the lower brackets on down. Should their other income bump them over the $231,450 threshold for the 33% bracket by, say, one dollar, they will only pay 33% in tax on that one dollar.
If you think of the RMD as the last money added, it is the money taxed at the highest rates. For instance, if they have $75,300 in other income, taking them right up to the 25% bracket line, any amount of RMD will be taxed at 25% or more.
All of this is before any other deductions and exemptions. Those serve to reduce your taxable income. While looking at all the possible variations is a discussion beyond the scope of this book, we can consider an example. For 2016 a married couple gets a standard deduction of $12,600 and personal exemptions of $8,100 ($4,050 each). In effect this means they don’t reach the 25% bracket until their AGI (adjusted gross income) reaches $96,000. ($96,000 - $8,100 - $12,600 = $75,300) So is there anything to be done? Possibly.
Assuming when you retire your tax bracket drops, you have a window of opportunity between that moment and age 70 1/2. Let’s consider the example of a couple who retires at 60 years old, using the numbers above.
They have a 10 year window until 70 1/2 to reduce their 401(k)/IRA holdings. They are married and filing jointly. For 2016:
The 15% tax bracket is good up to $75,300.
The personal exemption is $4,050 per person or $8,100 for our couple.
The standard deduction is good for another $12,600.
Add all this together and they can have up to $96,000 in income before they get pushed into the 25% bracket.
If their income is below $96,000, they might seriously consider moving the difference out of their IRA and/or 401(k) and taking the 15% tax hit.
15% is a low rate and worth locking in, especially given that 10 years from now their tax bracket could be twice that or more. It’s true they lose the money they pay in taxes and what it could have earned—as we saw with the Roth vs. deductible IRA discussion in the last chapter—but we are now only talking about ten years instead of decades of lost growth. So, if they have $50,000 in taxable income they could withdraw $46,000 for a total of $96,000. They could put the $46,000 in their Roth, their ordinary bucket investments or just spend it. Rolling it into a Roth would be my suggestion and is in fact what I am personally doing.
You don’t have to wait until you are 60 or even until you are fully retired to do this. Anytime you step away from paid work and your income drops, this is a strategy to consider. However, remember the further away from age 70 ½ you are, the more time you give up during which the money you pay in tax today could have been earning for you over the years.
There is no one solution. If as you approach age 70 ½ your 401(k)/IRA amounts are low, you can just leave them alone. If they are very high, however, starting to pull them out even at a 25% tax rate might make sense.
The key is to be aware of this looming required minimum distribution hit so that, as much as possible, you can take it on your own terms.
Once again, in this chapter we’ve touched a bit on tax laws and the information is current as of 2016. By the time you are reading this book the laws may well have changed. Be sure to look up the specific numbers that are applicable for the year in which you are reading.