The RMD Surprise for Retirees
“Save as much money as you can into your company 401k plan and take advantage of the company match”….It’s advice we hear all the time and advice that even us in the financial industry are proponents of. It’s not to say that this advice is wrong or even necessarily bad, but in working with many retirees I find that they haven’t realized how only putting money into their pre-tax retirement plans brings up a Required Minimum Distribution (RMD) surprise in retirement. You see, any money that someone has in their pre-tax 401K account or a Traditional IRA will be subject to RMD’s when they reach age 72. Essentially, the government requires that you withdraw a certain percentage of your funds and pay taxes on those withdrawals since you never paid taxes on them when they were deposited. The good news is that there are other options to consider for those currently working as well as those already in retirement.
Why RMD’s Exist in the First Place
When you save money into a pre-tax 401k plan or into a Traditional IRA you almost always get a tax deduction for doing so. Sometimes, this “deduction” occurs as the funds go into the retirement account (as is the case with a company 401k plan) and sometimes the deduction happens when you file your taxes (as is the case with a Traditional IRA). Either way, the funds go into these accounts WITHOUT having any income taxes assessed against them. Ultimately, the government gives you that benefit while you are working, but comes knocking at your door in retirement to collect all those taxes that they missed out on while you were saving. The Required Minimum Distribution is there way of dictating how much money you will be required to withdraw and ultimately how much taxes they will be able to collect on these withdrawals. From age 72 onwards, they assess how much money you have in your pre-tax retirement accounts, add ALL of these funds together (even if they are spread across multiple accounts), and give you an amount you are required to withdraw as income the following the year.
Example: someone aged 72 in 2022 with $1,000,000 in pre-tax retirement accounts would be required to withdraw $36,496.35 this year and pay taxes on those withdrawals. That represents approximately 3.65% of the total balance and this percentage increases every year after age 72.
What You Can Do While Working to Help
Let’s be clear, saving money towards retirement (whether pre-tax savings or post-tax savings) is always a good idea. Again, it’s not that traditional 401K savings or Traditional IRA’s are bad vehicles, it’s that there may be ways to tweak how you save for retirement that will give you greater tax diversification down the line. While you are working, two main ways that you can reduce your future RMD burden in retirement are:
- Choose to save money into your Company’s ROTH 401K Plan instead of the Traditional 401K Plan. Most companies now offer a Roth option for their 401k. Any funds sitting inside Roth accounts will NOT be subject to RMD’s or ANY future taxes in retirement.
2. Consider putting money into a Roth IRA account. If you make too much to contribute directly to a Roth IRA, consider a backdoor Roth IRA strategy. You can learn more about the backdoor roth here: https://www.nerdwallet.com/article/investing/backdoor-roth-ira
What You Can Do in Retirement to Help
Maybe you are already well down the track with your retirement savings, OR you’re already in retirement and getting ready to deal with the pending RMD issue when you reach age 72. Again, extra income is not necessarily a bad thing, but some people get to retirement and realize they actually don’t need their RMD income each year. Some high-level considerations that are worth looking into are:
- Consider Roth IRA conversions from your pre-tax retirement accounts. This is a way of shifting funds from your pre-tax retirement accounts to post-tax retirement accounts and paying taxes now to avoid potentially higher taxes down the line. Many times, it can be beneficial to delay claiming social security while you are doing these conversions which keeps your overall income picture lower.
2. Utilize Qualified Charitable Donations (QCD’s) from age 70 ½ and beyond. QCD’s are a way to send up to $100,000 each year to a charity of your choice which ultimately reduces the account balance of your pre-tax funds AND directly reduces your RMD requirement dollar for dollar.
3. Perhaps the least beneficial step, but still an effective one, is to re-invest your RMD funds into an after-tax brokerage account once you receive them. You would obviously still be paying taxes on the initial distribution, but if you don’t have a specific place you will be spending your RMD funds, it can be a way of at least earning interest on these funds moving forward.
Let me reiterate, RMD’s are not a terrible thing. However, it’s important to understand how they can impact your overall income in retirement and ensure you have a plan in place of how you will address this before it actually happens.