In retirement, you are on a limited budget. You are living off your life savings and your Social Security check. Any unexplained increase in your tax bill could dramatically affect your finances and cause you to outlive your money.
RMDs, or required minimum distributions, could cause this increased tax bill. You need to account for RMDs in your retirement plan.
What are RMDs?
RMDs, short for required minimum distributions, are the distributions the U.S. government requires from retirement accounts each year.
RMDs only kick in after you turn 72.
RMDs are applied to retirement accounts that are funded by pre-tax money. These accounts include traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k)s, 403(b)s, 457(b), profit sharing plans, and other defined contribution plans. With accounts that are funded by post-tax money, RMDs are not required.
RMDs exist because you have not paid taxes on the money in these accounts yet and the government does not want to delay getting their portion of this money any longer.
RMDs are calculated by every year by using the balance in your retirement accounts, your age, and your life expectancy according to the IRS’s “Uniform Lifetime Table”.
How does taking RMDs increase my tax bill?
If your income is low enough, taking RMDs is not really going to affect your tax bill.
If you are right on the edge of a tax bracket, or have a higher income, RMDs can really increase your taxes.
You are basically adding additional income to your tax return. If you do this without planning for it, it could affect many different aspects of your financial life.
How does taking RMDs increase my Social Security taxes?
Taking RMDs can increase your Social Security taxes significantly.
As we mentioned above, when you take RMDs, it is counted as taxable income.
Taxes on Social Security are calculated by looking at your combined income. Combined income is your adjusted gross income + nontaxable interest + ½ of your Social Security benefits.
If this amount comes to more than $25,000 as an individual or $32,000 as a couple, a portion of your Social Security benefit will be taxed.
This is scaled, and only 85% of your Social Security benefit is subject to taxation, but the more you increase your income, the more your Social Security check can be taxed.
This is important to keep in mind when planning for RMDs.
How does taking RMDs increase my Medicare costs?
IRMAA, or Income Related Monthly Adjustment Amount, is a surcharge that is placed on Medicare Part B and Part D premiums for high income earners.
IRMAA charges are tiered based on your income from 2 years prior, but in the top tier, as much as an additional $6,000 can be added onto your Medicare costs a year.
In 2021, if your income is over $88,000 as a single filer, or $176,000 as joint filers, you will be subject to IRMAA charges.
With Social Security, possible pension payments, and other sources of income coming in even after starting Medicare, adding distributions from retirement accounts can cause many people to be unexpectedly thrown into IRMAA.
Especially if you wait until age 72 to take distributions, it will likely be larger distributions, due to the fact that you have not lowered the account balance at all. This could significantly impact the price you pay for your Medicare.
RMDS are different in 2020 – The Secure Act
The Secure Act moved the age required minimum distributions started from 70 ½ to 72. This does not mean you have to wait until 72 to draw from your retirement accounts. You can start withdrawing from retirement accounts, without penalty, starting at age 59 ½
This year, in 2020, RMDS were different due to the Cares Act, which was passed in response to the Coronavirus pandemic.
The Cares Act did away with RMDs for 2020, meaning no one was required to take them for the year. It also allowed beneficiaries who already took RMDs in 2020 to put them back into their retirement accounts.
While this might seem like a nice reprieve, it could create a larger problem down the road.
If you did not take an RMD this year, that means your RMDs in the following years will be increased. For some, this will be a significant increase, meaning your tax bill, and the possibility of Medicare and Social Security taxes, being increased.
If you are at a lower income in 2020, you might want to consider still taking out RMDs for this year, which will make your distributions in the following years smaller.
There are other strategies that you can put into place now to reduce your RMDs in the upcoming years.
How can I avoid having to take RMDs?
If you have an account that requires RMDs, there is no way to avoid it. You, or your heirs, are going to have to pay taxes on this money at some point.
RMDs are the government’s plans for your distributions, but this is not going to be the best plan for most people.
If you are younger, there are a lot of things you can put into place to eliminate or greatly reduce the amount of RMDs you will have to pay when you turn 72.
The most effective strategy to do this is a Roth IRA conversion. A Roth IRA doesn’t require RMDs as you use post-tax money to fund it.
Even if a Roth IRA conversion won’t work for you, there are many other strategies you can put into place, no matter your age, to have a better plan for retirement account distributions than required minimum distributions.
Ideally, you would be down to your last dollar in your retirement account right before you die, since these accounts are meant to fund your retirement. Working with a CFP to come up with a plan for distributions can make sure you get as close to this as possible.