As your tax-deferred accounts (like pre tax 401ks/403bs/SEP IRAs and traditional IRAs) grow over time, so does your future tax liability.
Once you hit age 73 or 75 (depending on your birth year), the IRS forces you to start withdrawing money via Required Minimum Distributions (RMDs).
If your balances in traditional IRAs/401(k)s grow too large, paired with pensions, Social Security, and other income, it could cause a “tax tsunami”
For example, say you and your wife are maxing out your 401ks for 30 years. This could grow to ~$4.3M by the time you are ready to retire at 60 with a modest 7% growth rate. By the time you are 73, it could be $10M without any withdrawals.
At this stage, the life expectancy factor is 26.5, and the RMD will be:
$377k of RMDs, paired with any Social Security income and dividends, can easily result in a 32% marginal rate for a married couple. And this amount will likely only grow in the future.
My goal is to help you think strategically about the use of tax-deferred accounts and share some strategies for minimizing the pain of super-large RMDs:
1. Start considering pulling your pre-tax 401(k)s at 59½
One of the strategies is to shrink the size of your tax-deferred accounts before RMDs kick in.
Once you hit age 59½, you can begin withdrawing from your 401(k) or IRA without the 10% early withdrawal penalty.
Now, it’s important to understand that if you are still working at that age and have a regular income, it might not be worth it to do so. You have to analyze your future RMD amount (and associated marginal rate) vs your current marginal tax rate.
If you’re in the 12% marginal tax bracket now but would be in the 24% bracket once RMDs and Social Security hit, it makes sense to “pre-pay” some of that tax by withdrawing today.
2. Smart asset allocation
One of the recommended principles of portfolio “construction” is to figure out your ideal asset allocation.
For example, it could be 80% stocks and 20% bonds, or 95% stocks and 5% bonds. It all depends on your risk profile and goals (preservation vs growth)
Well, the best place to keep bonds is in tax deferred accounts because you don’t have to pay taxes on the interest generated from bonds (see my prior newsletter about “asset location”) This also “slows down” the growth of tax-deferred accounts rather than using something like a brokerage account (more flexible and with a step-up in basis) or Roth.
I’m not saying that you should go 100% in bonds to slow down the growth of your tax deferred. That would be unwise. But rather, figure out your ideal AA and keep bonds in tax-deferred accounts while putting faster growing assets (like stocks/ETFs) in taxable or Roth accounts.
3. Plan ahead
If you’ve done well financially, you should be aware of the Rule of 55. It allows you to withdraw from your 401(k) without penalty if you leave your job in or after the year you turn 55 (assuming your employer allows for partial distributions)
This early retirement gives you a tax planning window between RMDs and when Social Security kicks in.
What do you do during this window?
4. Do Roth Conversions
The idea here is to move money from tax-deferred to tax-free buckets while your taxable income is low.
If you wait to claim SS until age 70, you postpone adding that income to your tax return, giving you room to do Roth conversions at lower tax rates.
Roth conversions also help lower your future RMDs, since Roth IRAs don’t have RMDs.
Try to convert just enough to stay below IRMAA thresholds. You can also use taxable accounts for living expenses while doing Roth conversions to minimize taxes and live off them.
See: “How to pay no taxes in retirement”
If you retire at 55 and delay Social Security until 70, that’s 15 years to shrink your tax-deferred balance before RMDs/SS hit.
5. Be smart about Roth vs Traditional during working years.
Don’t blindly choose pre-tax contributions just for the short-term tax break. If you expect higher income (and therefore a higher marginal tax rate) or higher taxes in retirement, Roth may be the smarter option depending on your circumstances.
It’s hard to predict with 100% accuracy, but we can make some reasonable estimates.
For example, you can project your current 401(k) balance based on the expected growth. Multiply it by 4% withdrawals. You can use the SSA website to estimate your SS benefits. Etc.
6. Strategic giving
At age 70 and older, you can direct up to $108,000 per year from your IRA directly to charity through a QCD.
This counts toward your RMD, but doesn’t show up as taxable income, and you can also take the standard deduction.
This also helps you avoid IRMAA surcharges, NIIT, and other income means tested thresholds.
So, if you are planning to donate to any charities, be aware of this option and it might not make sense to convert depending on the amount.
Overall, being aware about the rules and expectations around RMDs can help you save $$ on taxes.
I hope you enjoyed this one.
Chat next week,
MC, CPA.