Avoiding RMD Pitfalls
While the passage of the SECURE Act bumped up the starting age for Required Minimum Distributions (RMDs)¹, we still encounter clients who avoid planning for RMDs until the first year they are due. Even worse, some put off taking them until the very END of that calendar year. While on the surface Required Minimum Distributions seem inevitable, they can be managed when given the proper time to strategize.
To best understand the implications of RMDs, you must first understand what they actually are. A Required Minimum Distribution is the minimum amount of money you must withdraw from certain retirement accounts starting at age 72*. Every age corresponds to a specific distribution period, which, when converted to a percentage, tells you what percentage of your account balance must be distributed in that calendar year. If you fail to withdraw at least this amount in any given year, you will face a 50% excise tax on the funds you failed to distribute. A 50% penalty is no joke, so ignoring RMDs in the hopes they go away is not a viable course of action. Whenever possible, they should be planned out in advance, particularly if the distribution will come from a tax-deferred account. Any tax-deferred distributions will count as taxable income for the year they are withdrawn, so you can end up paying more in taxes if they push your Adjusted Gross Income (AGI) into a higher tax bracket.
Thankfully, federal retirees are at a distinct advantage because they know, with a relatively high degree of precision, what their fixed income will be for any given year. Right off the bat, feds can account for their federal pension, any military pensions (if applicable), and FERS Supplement or Social Security payments. Then it comes time to account for regular distributions from tax-deferred accounts, like Traditional 401(k)s, TSPs, IRAs, 403(b)s, and 457(a)s. RMDs from these accounts will count toward your AGI for the year. You will also be subject to RMDs for all Roth 401(k)s, TSPs, 403(b)s and 457(a)s, but as long as they’re vested, they won’t count towards that year’s taxable income. Each of these accounts will have their very own RMD. Do keep in mind that any regular distributions you take will count towards that account’s RMD for the year, but you do need to make sure you reach the minimum value stipulated.
The tax consequences of RMDs, including both the penalties for not taking them and their potential to push you into a higher tax bracket, cause many people to seek ways around them. The only way to completely avoid RMDs is by housing your assets within a Roth IRA. If you are the original account owner, your Roth IRA is NOT subject to RMDs of any kind². The government can’t tell you to take it out, so you are welcome to preserve those funds within that account for as long as you’d like. Many feds have expressed that they wish they knew about the benefits of Roth IRAs sooner. Worry not! One of the best kept financial secrets is Roth Conversion, the process of converting your Traditional assets into Roth assets over time, paying the requisite taxes as you convert. This results in non-taxable, RMD-free Roth funds that you can use entirely at your own discretion for life. It can make good sense to start executing on Roth Conversions as soon as you enter retirement and find yourself in a lower tax bracket. Others want to start executing on them while they’re still working, as they’d like to lock in the tax bracket they’re in now to avoid potential tax hikes in the future.
PARCO’s new tax preparation and accounting services assist clients in calculating their Adjusted Gross Income for the year. We then determine how much “room” a client has to the top of their current tax bracket. This “room” is our first focus when executing Roth Conversions as it insulates clients from jumping into a higher bracket. Upon conversion, clients pay the requisite taxes, and the net balance moves into their Roth IRA**. As a result, our clients lessen future RMD obligations while increasing their Roth IRA balances, which are free from any future tax implications (once vested). The more years you have between retirement and RMDs, the more years you have to convert, greatly reducing and possibly eliminating future RMDs altogether. If you’re interested in learning about whether or not Roth Conversion makes sense for you, reach out to us.
*as long as you did not reach age 70 ½ in 2019.
**You can not complete Roth Conversions directly within the TSP. Funds must be rolled over into a Traditional IRA and then converted into a Roth IRA.
Comments and information provided on this article are for informational purposes only and shall not be relied upon as official tax advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
¹United States, IRS, “Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs)”, Internal Revenue Service. https://www.irs.gov/publications/p590b#en_US_2019_publink1000231238
²United States, IRS, “Retirement Plan and IRA Required Minimum Distributions FAQs”