Required Minimum Distributions

RMD. If you’re seventy years old, or near it, or you have inherited an IRA from someone, you have probably heard this acronym.

Most retirees have some basic understanding that they need to take money out of their pre-tax retirement accounts at age seventy and a half. Not many understand all the ins and outs of managing them. Even fewer understand the impact Required Minimum Distributions, and the corresponding tax liability, will have on the value of their nest eggs, and the taxation of their other sources of income.

The primary benefit of saving money in a traditional IRA or 401(k) is tax deferral, and in the case of a 401(k), if you’re lucky, a matching contribution from your employer. The money goes in before taxes are withheld, and the earnings accumulate, uninterrupted by taxation. Until it’s time for RMDs.

In my experience, most people end up taking money out of their IRAs well before age seventy and a half, and they take well more than they are required to, because they need or want the money for expenses. These folks are rudely awakened to the impact their withdrawals, and the tax liability, have on the value of their accounts.

For those fortunate enough to have the luxury of not needing or wanting money from their pre-tax accounts until age seventy and a half (isn’t it weird that the rules are made around half ages?), the addition of this income can be a source of frustration. “No one told me I was going to have to take all this money out and pay tax on it” and “If I’d known this was how it worked, I wouldn’t have put my money in this thing” are comments we’ve heard in our office.

Whether you need or want the money, or not, the IRS is going to make you take it out, and pay tax on it. They don’t care if you spend the net proceeds, or if you reinvest them, but they’re going to make sure you take it out of the pre-tax plan, and give them their cut. The fifty percent penalty for failing to do so is a very strong motivator.

Some one may have told them that they’ll be in a lower tax bracket when they retire, so putting money in this account will save taxes. And selective human hearing translates this to “you’ll pay very little tax on the money later” or maybe even “you won’t pay tax on it later”. But other than a very small increase in the standard deduction and exemption amount after age sixty-five, the tax brackets don’t change by age.

I find most folks don’t want to have less income the day after they retire, so almost all of the people I have walked from their working years into their retirement years are paying the same effective tax rate they were before, or more. And we’ve had declining tax rates since the 1980’s.

So when you step back and look at how these things really work, they don’t save taxes, they postpone them. Funny the government doesn’t call them “tax postponed” plans. Something tells me they wouldn’t sell as well.

Here’s some context for you: let’s say I pay a twenty percent effective Federal income tax rate. It’s April 15th and my tax preparer or financial advisor tells me I could reduce my tax bill by $1,000 if I make a traditional IRA contribution of $5,000. Great! Where do I sign?

But where does that $1,000 go? Do you think most people set that money aside to make sure they have it for when RMDs begin?

Mmmm no. I spend it. So in effect, I’m borrowing that $1,000 from the IRS. And I’m borrowing it at a to-be-determined interest rate. If you asked me for a loan and I said sure, I’m flush right now, I’ll let you know what interest rate you’ll pay me when I figure out how much money I need later, would you take that loan? Probably not.

But wait, it gets better.

Once we retire and forgo the ability to earn a paycheck, what we have becomes very, very finite. And our financial flexibility declines sharply.

I have a client, we’ll call her Jane. She retired with a good amount of money that her physician husband left her when he died, in his SEP IRA. After she retired, her expenses stayed at roughly the level they were at before she retired, and for the first year or two, everything went along as planned. And then she took a little extra out one year to help one of her kids. She was unpleasantly surprised by the tax bill the following April, and found she had to take a little more out just to pay the tax on the little more she took out the year before. I see this a lot. I call it the IRA downhill snowball.

When you begin taking your RMDs, if your account grows after this point, so does the RMD amount, because the government wants you to take all the money out and give them their cut before you die. So increasing RMDs also means higher taxable income, potentially an increasing marginal tax bracket, and almost always, an increasing portion of your Social Security benefit being subject to income tax, driving your effective tax rate even higher. And yes, lots of people are surprised to learn that their Social Security will be taxed too.

Now, you might say: “But Brendan, the government is saying they’re going to lower taxes. Maybe that will save me.” You might not guess from the tone of this blog at times, but I am an optimist. I believe in the power of love, and that the truly remarkable adaptability of the human species will lead us to new heights. But if you tell me you believe the government is going to lower taxes for the likes of you and me, and that this will rescue your retirement income plan, I can assure you I will not laugh, but I will be compelled to tell you that you are setting yourself up for disappointment and maybe disaster.

Our national debt is as high as it was during World War II. Our Medicare and Social Security benefit payments are draining the money our politicians want to give their friends. Mark my words: the government will be taking more of your money in the future, not less.

But back to RMDs. After all this, traditional IRA’s and 401(k)s are not in and of themselves, bad. The problem lies in the lack of understanding people (financial and tax advisors too), have of them, and the fact that this is what people are being driven to put all of their retirement savings in. If more truly understood how these accounts work, they would balance what they save among vehicles that offer another form of tax treatment. They would develop a strategy for balancing the tax they pay now, AND in retirement.

If you want to develop a strategy like that, give us a call. It’s what we do all day every day.