How RMDs Can Affect Your Retirement Tax Picture

How RMDs Can Affect Your Retirement Tax Picture

Required Minimum Distributions, or RMDs, are often treated like a future administrative task. For many retirees, they are much more than that.

RMDs can change the retirement tax picture because they force withdrawals from certain retirement accounts once the applicable age is reached. These withdrawals are generally taxable as ordinary income. If the account balance is large, the required distributions can become significant.

The issue is not simply that retirees must take money out. The issue is that RMDs can reduce tax control.

What Are RMDs?

RMDs are minimum amounts that must be withdrawn from certain retirement accounts each year after the account owner reaches the required beginning age. These rules generally apply to traditional IRAs, SEP IRAs, SIMPLE IRAs, and many employer retirement plans.

The required amount is generally based on the prior year-end account balance and an IRS life expectancy factor.

RMDs are not optional. Failing to take them can result in penalties. The exact rules can vary based on account type, age, employment status, beneficiary status, and other circumstances.

Why RMDs Can Surprise Retirees

Many retirees do not need large withdrawals early in retirement. They may live on Social Security, a pension, cash, brokerage accounts, or smaller IRA withdrawals.

Meanwhile, their IRA or 401(k) continues to grow.

That growth can be positive, but it can also create a future tax issue. When RMDs begin, larger account balances can produce larger required withdrawals. The retiree may be forced to take income that is not needed for spending.

That income can affect more than one line on the tax return.

RMDs and Income Taxes

Traditional IRA and 401(k) withdrawals are generally taxable as ordinary income. RMDs from those accounts can increase adjusted gross income and taxable income.

This may push some retirees into higher tax brackets or reduce the ability to manage income from year to year. The goal is not always to eliminate RMDs. That may not be possible or appropriate. The goal is to know what they may look like before they begin

RMDs and Social Security Taxation

Social Security benefits may be taxable depending on combined income. RMDs can increase income and may cause a larger portion of Social Security benefits to be included in taxable income.

This is one reason retirement income planning should be coordinated. A retiree who looks only at the IRA withdrawal may miss the additional tax impact created by the interaction with Social Security.

RMDs and Medicare Premiums

Higher income can affect Medicare premiums through IRMAA, the Income-Related Monthly Adjustment Amount. IRMAA can apply to Medicare Part B and Part D when income exceeds certain thresholds.

Because RMDs can increase income, they may contribute to higher Medicare premium exposure.

A retiree may think, "I only took my required distribution." But from a Medicare perspective, that required distribution may still count as income.

RMDs and the Widow's Penalty

RMD planning is especially important for married couples.

If one spouse dies, the surviving spouse may eventually file as a single taxpayer. The household may have lower income, but not necessarily half as much income. If the surviving spouse inherits the retirement accounts, future RMDs may continue.

This can create higher tax pressure for the survivor.

A good RMD strategy should look not only at the couple's current tax return, but also at the potential tax return of the surviving spouse.

RMDs and Roth Conversions

Roth conversions are one possible strategy to manage future RMD exposure.

By converting some pre-tax retirement assets to a Roth account, a retiree may reduce the balance left in accounts subject to future RMDs. The converted amount is generally taxable in the year of conversion, so this strategy requires careful analysis.

The planning question is whether paying some tax now may reduce forced taxable income later.

RMDs and Charitable Giving

For charitably inclined retirees, Qualified Charitable Distributions, or QCDs, may be worth reviewing once eligible.

A QCD allows an eligible IRA owner to direct money from an IRA to a qualified charity. A properly executed QCD may count toward the RMD while excluding the distributed amount from taxable income, subject to limits and rules.

This can be especially useful for retirees who give to charity and do not itemize deductions.

RMDs and Beneficiaries

Large pre-tax accounts can also create tax issues for heirs.

Under current rules, many non-spouse beneficiaries must distribute inherited retirement accounts within 10 years. If adult children inherit traditional IRA assets during their peak earning years, the inherited withdrawals may add taxable income during an already high-income period.

RMD planning during life may affect the tax burden passed to the next generation.

Common RMD Mistakes

Retirees should watch for these mistakes:

• Waiting until RMD age to start planning

• Assuming lower withdrawals early in retirement are always better

• Ignoring future tax brackets

• Ignoring the surviving spouse's tax situation

• Ignoring Medicare premium thresholds

• Taking the first RMD at the wrong time without understanding the tax effect

• Failing to coordinate multiple retirement accounts

• Missing QCD opportunities

• Ignoring inherited IRA rules for beneficiaries

The Better Question

The question is not only, "What will my RMD be this year?"

The better question is: "What will my RMDs look like over the next 10, 15, or 20 years, and what can be done now to create more tax flexibility?"

Final Thought

RMDs are not just withdrawals. They are a retirement tax planning issue.

The earlier they are projected, the more options a retiree may have. Once RMDs begin, the planning window may narrow.

disclaimer:

Asset Maximization Group provides educational information and retirement planning strategy. This material is not intended to provide individualized investment, tax, or legal advice. Tax laws and retirement rules can change, and their impact depends on each person's circumstances. Clients should consult their qualified tax, legal, and financial professionals before making decisions regarding investments, withdrawals, Roth conversions, estate planning, or insurance products. Investing involves risk, including possible loss of principal. Guarantees, where applicable, are backed by the claims-paying ability of the issuing insurance company.