Savvy Tax Move #1
Time your RMDs and other income
The IRS doesn’t care when or how often you take distributions to satisfy your RMDs—as long as you withdraw the appropriate amount by Dec. 31 each year. There’s one exception: You can wait to take your first distribution until April 1 of your 74th year. This is important because if you have a large income event in your 73rd year, you may decide to wait until the next year so your income tax rate is lower. And vice versa if you have a liquidity event in your 74th year—you can take your RMD in your 73rd year instead.
A word of caution—if you choose to wait until the next calendar year to take your first RMD, you’ll have to receive another before the end of the same year. That’s double the distribution amount (and thus higher taxes owed) in one year.
Additionally, if you need more income than your RMD provides, consider drawing upon other income sources so you don’t jump to the next tax bracket. For instance, if your ordinary income rate is higher than the long-term capital gains rates, you may wish to generate income by selling appreciated long-term securities. Or consider ways to use tax losses from investments to offset gains and other income.
Eliminate your RMDs
Individuals who don’t need their RMDs can eliminate all or part of them by converting their retirement accounts to a Roth. Roth accounts do not pay tax on distributions—whether it’s a withdrawal of your contribution or the appreciation on your money. In other words, after contributing after-tax money, Roths can potentially grow tax-free for your entire life.
And, notably, there are no RMDs from your own Roth accounts. So that means when someone converts from a traditional to Roth IRA and pays tax on the converted amount (in the year of the switch), they’re done paying tax on those funds and any gains from those funds—FOREVER!
Let’s walk through hypothetical illustrations with two different goals.
Goal #1: Minimize taxes, no legacy
Devin and Sammy, a 64-year-old married Florida couple, just retired after selling their business for $1.6 million. They are working with their Wealth Advisor on a retirement budget. In addition to the proceeds from the sale, they have a $1.75 million traditional IRA. Here are the details of their plan. They:
- feel confident they can live on $100K per year
- have enough money to cover this annual spend, so they don’t plan to take Social Security until age 70
- are not interested in leaving a legacy at this time
They asked their Advisor how they can reduce their taxes on their income from Social Security and their RMDs from their traditional IRA when they need to take them.
Their Advisor suggested a Roth conversion. Her analysis shows they should convert no more than 50% of the $1.75 million to a Roth, spreading the conversion over the next five years when their income tax rate should be lowest—a tax bracket trough—since they’ll have no other income until Social Security kicks in.
Calculations by Motley Fool Wealth Management. Married couple filing jointly. Total taxes paid is discounted at 2.5% to today's dollars through age 85. Maximum tax rate excludes tax rate on transfer to heirs. Assumes traditional IRA is invested in a balanced portfolio that delivers a market return of 5.38% from ages 63-70, then 4.72% return through age 85. Taxable income starting at age 70 from Social Security ($75,000 per year) excludes the 15% of Social Security not taxed. Past performance is not indication of future results. For illustrative purposes only.
In both scenarios, Devin and Sammy pay taxes of $273,380 on the initial sale of the business (income of $1,600,000 less the standard deduction of $27,700 = $1,572,300). The differences start at age 65:
- No conversion: Over the next five years (ages 65-69), they have no income and pay no income tax. At age 70, their tax rate would only be 12% through age 73 when their RMDs kick in. From ages 73 through 82, their tax rate would be 22%, then kick up to 24% through age 85.
- Convert 50%: Over the next five years (ages 65-69), their income tax rate will be 24% on the amount they convert. Then it would fall to 12% through age 83. After that, it would go up to 22%.
When asked about converting more, the analysis shows that shifting more than 50% would generate higher taxes paid than not converting at all, which is contrary to their goal.
Goal #2: Minimize taxes, leave a legacy, and increase annual cash available
After careful consideration, Devin and Sammy decide they want to both lower their taxes and maximize the amount they can leave for heirs. But they’re also concerned about rising health care costs in their 80s and want to make sure they have at least $125K available each year during those years.
In this case, their Advisor suggested a 40% conversion. Like the 50% conversion, their taxes would be lower than not converting at all. In addition, Devin and Sammy would confidently have the desired $125K available each year in their 80s from their Social Security benefits and the non-converted portion (60%) of their RMDs without dipping into their Roth savings. (If they do not convert, they would also have sufficient funds to meet their desired $125K, but if they convert 50%, they would only have between $115K-$122K each year and may need to dip into their Roth savings.)
Finally, they would be able to leave nearly $1 million more—$2.85 million vs. $1.85 million—to their heirs than if they did not convert. And even more importantly, almost all—$2.1 million out of the $2.8 million—will be in a Roth, so their heirs likely will never have to pay taxes on the inherited amount. If they don’t convert, their heirs will need to withdraw the inherited IRA over 10 years (same time frame as a Roth) AND pay taxes on the full amount.
Do not convert vs. Convert 40%
Calculations by Motley Fool Wealth Management. *Discounted at 2.5% to today's dollars through age 85. Does not include a hypothetical/assumed 30% tax on inherited amount. **Excludes tax rate on transfer to heirs. Assumes traditional IRA is invested in a balanced portfolio that delivers a market return of 5.38% from ages 63-70, then 4.72% return through age 85. Past performance is not indication of future results. For illustrative purposes only.
Distribute your RMDs
Instead of donating cash or an appreciated security, you can give your RMDs from your retirement accounts to a cause you care about. This qualified charitable distribution (QCD) could make sense if you…
- would like to donate to charity during your life, or
- will not need your full RMD to support your living expenses, or
- do not have heirs, or do not prioritize leaving money to heirs.
QCDs are gifts to qualified public charities that, when done correctly, count toward your RMD each year. And more importantly, QCDs cancel out any tax you would have to pay on the RMD.
Let's take another example—Joe and Corinne, a retired couple weighing their options on making a $50K donation to their favorite charity. They planned on gifting cash, but their Wealth Advisor explained there could be a better way.
Let’s say they file their taxes jointly. They have a combined annual income of $24K from a pension, $50K in Social Security income (of which 85%, or $42,500, is taxable), and $50K of RMDs. Remember, RMDs areconsidered incomeand taxed at ordinary income rates.
Their Advisor computed two scenarios:
- Withdrawing their RMD, making a cash donation of $50K, and taking it as an itemized deduction on their tax return
- Making a QCD of $50K and taking a standard tax deduction
Here are the results of her analysis:
Source: Motley Fool Wealth Management. This analysis is hypothetical and for illustrative purposes only. For guidance and advice on taxes, consult your tax professional.
In both scenarios, Joe and Corinne gifted $50K to their favorite charity. But by making the QCD instead of a cash donation and taking the standard deduction, Joe and Corinne lowered their taxable income by the amount of the standard deduction, $27,700, resulting in paying $3,324 less in taxes—a 44% reduction.
There’s another important consideration: health care costs. (Yup, this again!) Making a QCD that reduces taxable income may mitigate exposure to Medicare Parts B and D income limits. In other words, the lower your income, the less you pay in Medicare premiums. So a potential benefit of making a QCD instead of taking an RMD is it may reduce the amount you pay for health care each year.
Of course, these decisions involve your individual tax situation, so always consult with your tax professional.
