Conscientious clients have spent decades saving for retirement, taking advantage of tax-deferral from accounts like 401(k)s and traditional individual retirement accounts (IRAs).
Many, however, are surprised years later to learn that there were strings attached. They owe taxes when they withdraw assets. And they may have to withdraw more than they need because of required minimum distributions (RMDs).
As their advisor, you can take the surprise factor out of distributions from tax-deferred accounts and:
• Save your clients thousands of dollars in taxes and maximize their retirement income.
• Demonstrate the value of account consolidation as a run-up to retirement.
• Retain more assets under management when clients make deliberate rather than haphazard withdrawals to pay investment taxes.
Here are answers to some of the questions I often hear from investors and advisors about RMDs.
Isn’t the age for RMDs higher than it used to be? Do clients still need to worry about RMDs? Congress in 2019 raised the age when RMDs need to begin from 70½ to 72. Legislation passed earlier this year by the House of Representatives would gradually raise the age to 75. The bill is now in the Senate, and its fate is anyone’s guess.
Whatever happens, this fact endures: clients need to worry about taxes they’ll pay on IRA withdrawals over their entire retirement. Delaying withdrawals may lead clients to pay more taxes on concentrated RMDs later.
Who needs to worry about RMDs, and what should they do? Individuals with even moderate-sized IRAs and small brokerage accounts must worry about sequencing withdrawals. Delaying withdrawals from IRAs or 401(k)s early in retirement can lead to higher taxes later on concentrated required withdrawals (remember, withdrawals are taxed as ordinary income).
In another scenario, clients have to meet a significant, unanticipated expense. They could wind up depleting savings or brokerage accounts or voluntarily withdrawing funds from tax-deferred accounts while in a higher income tax bracket. In the latter case, they still have to take an RMD (and pay its tax bill) the following year.
By the time someone has an emergency, the opportunity to plan and save on taxes may be lost since clients can only use voluntary withdrawals to fund Roth conversions.
Well-off individuals with large tax-qualified and brokerage accounts have the best opportunity to reduce their taxes by using deliberately executed IRA withdrawals. You can make a compelling case to your clients for:
1. Rolling up their accounts into one IRA if they’re single or two if they’re married.
2. Taking voluntary withdrawals early in retirement, when their other taxable income is reduced and before they have claimed Social Security benefits.
3. Using the withdrawals to fund Roth conversions. Their brokerage accounts can support their spending needs and the taxes they’ll owe on the IRA withdrawals.
What about estate planning? From a tax perspective, most wealthy clients benefit from emptying their IRAs before death. New rules have accelerated the schedules for disbursing inherited IRAs to beneficiaries, often adult children. The latter will probably be in their prime working years and subject to higher tax brackets than their parents were in retirement.
How about married couples? Married couples have different challenges and opportunities. The biggest challenge is that a widowed spouse, as a single filer, has about half as many options for deductions and tax bracket shifts as a couple filing jointly. That can lead to tax surprises for a survivor at a difficult time.
The opportunities lie in taking voluntary IRA withdrawals to manage tax liabilities while both spouses are living. These withdrawals will reduce RMDs (and taxes) for a surviving spouse.
Couples born in different calendar years have different RMD rates. Couples often benefit from voluntary withdrawals from the older member’s IRA to reduce their combined RMDs. The voluntary withdrawals can fund Roth conversions.
Who doesn’t need to worry about RMDs? Individuals with small IRAs (or equivalents) do not need to worry about RMDs. They’ll need their withdrawals to support their retirement spending. Their more significant concern is outliving their savings. Often, they should delay retirement and Social Security benefits (to increase monthly payments) if they can.
When should people (and their advisors) begin to plan how to manage their RMDs and other IRA withdrawals? The answer: sooner rather than later. Years of retirement savings can make the transition to decumulation frightening and confounding. Inertia can set in. Clients fail to plan or take action to limit taxes over their retirement and extend the value of their savings.
Clients respond best to advice when presented with illustrated, multi-year charts that account for their income needs (collected in financial planning) and tax liabilities. Advanced income-sourcing software can help you deliver the latter.
Then, you can propose a course for RMDs and voluntary withdrawals from IRAs and brokerage accounts that support their spending needs and cover their tax bills—that you have successfully minimized.
Paul R. Samuelson is the chief investment officer and co-founder of LifeYield.