RMD and the tax trap

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Rick Ferri
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RMD and the tax trap

Post by Rick Ferri »

I've always been interested in the increasing tax burden that retirees with large IRAs have as the age and required minimum distribution (RMD) amounts increase. A recent tax article written for Forbes by William Baldwin titled How Retirees Pay Zero Taxes, prompted me to look into this further. Some people are definitely going have a tax surprise when they reach their golden years.

Avoiding Taxes As A Retiree Isn’t So Easy

Rick Ferri
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gerrym51
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Re: RMD and the tax trap

Post by gerrym51 »

the goal in retirement is not to avoid taxes. the goal is to never pay more than 15 percent taxes.
Bob's not my name
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Re: RMD and the tax trap

Post by Bob's not my name »

Ten years ago, the couple retired with an IRA account worth $2 million. They did not take any money out on the advice of their adviser. The account earned 7% per year since retirement, and is now worth $4 million. Through good financial planning described in Mr. Baldwin’s article, they have paid no federal taxes in retirement thus far.
I don't get it. Why wouldn't this wealthy couple have used that tax-free decade for Roth conversions at low tax rates?
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Re: RMD and the tax trap

Post by Wagnerjb »

Bob's not my name wrote:
Ten years ago, the couple retired with an IRA account worth $2 million. They did not take any money out on the advice of their adviser. The account earned 7% per year since retirement, and is now worth $4 million. Through good financial planning described in Mr. Baldwin’s article, they have paid no federal taxes in retirement thus far.
I don't get it. Why wouldn't this wealthy couple have used that tax-free decade for Roth conversions at low tax rates?
I agree with NotBob.

I suspect the best strategy is a smooth taxable income stream. During those 10 years, convert aggressively to a Roth. Then use the Roth after age 70.5 to supplement the IRA distributions for living expenses.

Best wishes.
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Higman
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Re: RMD and the tax trap

Post by Higman »

Rick - typo in your article. It is AGI, not AIG. Fixed.
Last edited by Higman on Mon Jun 10, 2013 6:51 pm, edited 1 time in total.
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Re: RMD and the tax trap

Post by Epsilon Delta »

Bob's not my name wrote:
Ten years ago, the couple retired with an IRA account worth $2 million. They did not take any money out on the advice of their adviser. The account earned 7% per year since retirement, and is now worth $4 million. Through good financial planning described in Mr. Baldwin’s article, they have paid no federal taxes in retirement thus far.
I don't get it. Why wouldn't this wealthy couple have used that tax-free decade for Roth conversions at low tax rates?
Because they spent those years gloating how they paid zero taxes?
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Re: RMD and the tax trap

Post by staythecourse »

I have said for years the biggest advantage of ROTH ira's is 1. No RMD and 2. No federal taxation to heirs.

HUGE advantages for those who may end up with more then enough money to live off during retirement then they need and through the course of their lives.

Good luck.
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Re: RMD and the tax trap

Post by umfundi »

Rick,

Can you summarize the taxation pros and cons of using the IRA for living expenses up to age 70, and deferring Social Security? Let's say a single person uses $25k per year from the IRA rather than take SS at age 62.

Thank you,

Keith
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House Blend
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Re: RMD and the tax trap

Post by House Blend »

The Forbes article is nearly useless, and Rick has pointed out one of the reasons. Some others:
Defer Social Security and IRA distributions until age 70. Live off non-IRA assets.
Deferring IRA distributions before age 70 is a mistake if you are in a lower bracket than you will be after age 70 with RMDs. You should be doing Roth conversions up to the top of that lower bracket.

The article does a great job of losing track of the fact that the goal is to maximize income/wealth, not minimize taxes.

I too can invent mythical couples that have high incomes and pay no income tax.

Have $10M in a 401k? Convert it to Roth before you retire. All at once. Poof! Magically you'll pay no income tax in retirement.

Have $10M in muni bonds? No income tax for you! (Let's ignore how you accumulated the capital in the first place, and whether the principal was ever taxed, and whether you might get a better return after tax with a balanced portfolio of stocks and bonds.)

Also, it's easier to pretend that you aren't paying income tax when it is (a) paid to foreign countries (note the use of the FTC), or (b) paid to your state.
Our Boston-area example has, besides the property tax, a $4,998 tab for state income tax.
I guess state income tax doesn't count when trolling for page views.
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Re: RMD and the tax trap

Post by Johm221122 »

I will gladly pay taxes on my portfolio at RMD time, it will mean that my withdraw rate was safe.But for those with large portfolio and wishing to leave an estate your right.But for those retiring early and needing to take 4% ,higher (than expected )RMD's is winning
John
Last edited by Johm221122 on Mon Jun 10, 2013 12:40 pm, edited 4 times in total.
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Re: RMD and the tax trap

Post by fundtalker123 »

Articles like this almost make it sound like it is a bad idea to end up with a lot of money in IRAs. But what is the alternative - just save in taxable accounts? Isn't that a worse idea? We are in the maximum possible tax brackets (federal + state) and have been putting the maximum possible pre-tax contributions into tax deferred retirement plans. They will probably accrue large amounts and be subject to large taxes upon required withdrawls, on top of taxes on pension income and taxable investments and SS (if solvent). But what else can we do that would be better? Unless we could predict that tax rates in the future would be considerably higher than now, it still makes the most sense to max out pre-tax contributions to retirement plans, right? We could also plan to move to a state with lower state taxes after retirement.
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Re: RMD and the tax trap

Post by Blues »

Timely article, Rick, as I have just been doing numerous calculations to try to determine whether to continue partial Roth conversions of my wife's tIRA, and if so, to determine how much (more) to convert annually. (Naturally, I have been trying to keep it right below pushing us into the next marginal tax bracket.)

As you say in the article, no matter how many ways we juggle the numbers there is going to be blood in the water in the form of additional taxes due, regardless. All we can do is try to minimize the hit.
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Re: RMD and the tax trap

Post by nisiprius »

Image

But when I signed up they told me taxes would be deferred!

Now you tell me that taxes on tax-deferred savings are only deferred?

What an ugly surprise! Who could ever have foreseen having to pay taxes on tax-deferred savings? Why didn't anyone ever explain it to me?

^^^^^^^^^
(Note: irony)
Last edited by nisiprius on Mon Jun 10, 2013 1:13 pm, edited 4 times in total.
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Re: RMD and the tax trap

Post by FinancialDave »

I have said for years the biggest advantage of ROTH ira's is 1. No RMD and 2. No federal taxation to heirs.

HUGE advantages for those who may end up with more then enough money to live off during retirement then they need and through the course of their lives.

Good luck.
I have said for years that there is no lifetime tax advantage to a Roth over an IRA given the same tax treatment on both ends - RMD or otherwise.

Since this "hypothetical" couple was probably very highly compensated during their working years, it was very possible their tax rates were 33% and beyond when this money was going into the IRA. In fact I seem to remember some of my tax years when 30% was a low tax rate on my modest salary.

If you look at all the years paying no tax rate and then a few years where they now have income say in the $175k range where they might have to pay an average effective tax rate that would be less than 30%, I would say they are not doing all that bad.

Sure it is possible for them to have made a much smarter decision along the way, but just looking at the end result is not the proper way to look at it. Maybe their goal is to let the kids pay the tax, at their much lower rate. After all the chart is a little mis-leading running the distributions out to age 100+.

fd
Last edited by FinancialDave on Mon Jun 10, 2013 12:41 pm, edited 1 time in total.
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Re: RMD and the tax trap

Post by YDNAL »

nisiprius wrote:But when I signed up they told me taxes would be deferred! Now you tell me that taxes on tax-deferred savings are only deferred?

Boy, you just can't trust 'em...
LOL!... great point.

The real trick is to defer when you would pay MORE taxes and pay LESS taxes later. :beer
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Re: RMD and the tax trap

Post by Rick Ferri »

Bob's not my name wrote:
Ten years ago, the couple retired with an IRA account worth $2 million. They did not take any money out on the advice of their adviser. The account earned 7% per year since retirement, and is now worth $4 million. Through good financial planning described in Mr. Baldwin’s article, they have paid no federal taxes in retirement thus far.
I don't get it. Why wouldn't this wealthy couple have used that tax-free decade for Roth conversions at low tax rates?
I agree. That's a good strategy. This wasn't a tax advice article; it's a tax awareness article. I'm not in the business of providing tax advice. Consult your tax adviser.

Rick Ferri
Last edited by Rick Ferri on Mon Jun 10, 2013 12:51 pm, edited 1 time in total.
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Re: RMD and the tax trap

Post by Doc »

If are lucky enough that

* You have no taxable accounts
* You don't need Social Security to live on
* You don't have a pension

then RMDs from traditional IRA's may be taxed at a zero rate.

I'm actually glad that I'm not that lucky.

Thanks Rick.
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Re: RMD and the tax trap

Post by FinancialDave »

YDNAL wrote:
LOL!... great point.

The real trick is to defer when you would pay MORE taxes and pay LESS taxes later. :beer
Exactly, and one strategy, which is a real trick if you can do it, is to convert your IRA to a Roth at a time when the IRA is down due to the market and then have it re-cover in the Roth.

:sharebeer
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Re: RMD and the tax trap

Post by Alan S. »

This "5 year rule" revenue raiser keeps re surfacing in proposed legislation. Therefore, parents leaving IRAs to their children cannot take much comfort in the latest news:
http://www.ascensus.com/CompanySite/Uti ... ewsID=1615
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Re: RMD and the tax trap

Post by MP173 »

My head hurts when I try to think of all the options for retirement.

Sometimes it appears that asset location is just as important as asset allocation.

Ed
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Re: RMD and the tax trap

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umfundi
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Re: RMD and the tax trap

Post by umfundi »

Alan S. wrote:This "5 year rule" revenue raiser keeps re surfacing in proposed legislation. Therefore, parents leaving IRAs to their children cannot take much comfort in the latest news:
http://www.ascensus.com/CompanySite/Uti ... ewsID=1615
What do you care? The law (if it is ever passed) will only affect you if you're dead.

Keith
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Bill M
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Re: RMD and the tax trap

Post by Bill M »

staythecourse wrote:I have said for years the biggest advantage of ROTH ira's is 1. No RMD and 2. No federal taxation to heirs.
+1 +1 +1
These advantages far outweigh the differential tax rates between working years and retirement years.
umfundi
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Re: RMD and the tax trap

Post by umfundi »

Bill M wrote:
staythecourse wrote:I have said for years the biggest advantage of ROTH ira's is 1. No RMD and 2. No federal taxation to heirs.
+1 +1 +1
These advantages far outweigh the differential tax rates between working years and retirement years.
Advantages which only accrue if you do not use the Roth for yourself.

Keith
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Re: RMD and the tax trap

Post by Bob's not my name »

Gifting to heirs also avoids federal taxation and RMDs. The step up basis also avoids taxation and RMDs. Realizing LTCG in the 15% bracket also avoids taxation and RMDs. Personal residence also avoids taxation and RMDs. What's unique about Roth is the propensity to make it an ACRONYM, and that makes it very special.
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Re: RMD and the tax trap

Post by YDNAL »

umfundi wrote:
Alan S. wrote:... parents leaving IRAs to their children cannot take much comfort in the latest news: <snip>
What do you care? The law (if it is ever passed) will only affect you if you're dead.

Keith
Keith,

-- Please refrain from discussing ANY sort of legislation --

Estate Planning IS intended for when a person IS "dead."
  • People can (and do) plan to have large IRAs inherited by their children, to be withdrawn based on current law.
  • From strictly a planning perspective, how is this plan above impacted if options 2-3 are not available ? Would you care ?

Code: Select all

4 Options for Non-Spouse Beneficiaries of Inherited IRAs

Option #1 - Cash Out the IRA Over 5 Years.
Option #2 - Take Out Required Minimum Distributions Over Your Life Expectancy.
Option #3 - Take Out Required Minimum Distributions Over the Account Owner's Remaining Life Expectancy.
Option #4 - Cash Out the IRA Account Immediately.
Lets also be pragmatic here and discourage anyone from burying their heads in the sand.
Last edited by YDNAL on Mon Jun 10, 2013 3:35 pm, edited 1 time in total.
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pastafarian
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Re: RMD and the tax trap

Post by pastafarian »

Bob's not my name wrote: What's unique about Roth is the propensity to make it an ACRONYM, and that makes it very special.
I'm game, what does the acronym Roth stand for? Right On To Hell, Replies Only Tangentially Helpful? :?

From Dictionary.com
ac·ro·nym/ˈækrənɪm/ Show Spelled [ak-ruh-nim]
noun
1. a word formed from the initial letters or groups of letters of words in a set phrase or series of words, as Wac from Women's Army Corps, OPEC from Organization of Petroleum Exporting Countries, or loran from long-range navigation.
2. an acrostic.
verb (used with object)
3. to make an acronym of: The committee's name has been acronymed MIKE.
umfundi
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Re: RMD and the tax trap

Post by umfundi »

Bob's not my name wrote:Gifting to heirs also avoids federal taxation and RMDs. The step up basis also avoids taxation and RMDs. Realizing LTCG in the 15% bracket also avoids taxation and RMDs. Personal residence also avoids taxation and RMDs. What's unique about Roth is the propensity to make it an ACRONYM, and that makes it very special.
Actually, ROTH means nothing. Roth is the name of the writer / sponsor of the law.

Wikipedia:
The Roth IRA was established by the Taxpayer Relief Act of 1997 (Public Law 105-34) and named for its chief legislative sponsor, Senator William Roth of Delaware.
Keith
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umfundi
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Re: RMD and the tax trap

Post by umfundi »

YDNAL wrote:
umfundi wrote:
Alan S. wrote:... parents leaving IRAs to their children cannot take much comfort in the latest news: <snip>
What do you care? The law (if it is ever passed) will only affect you if you're dead.

Keith
Keith,

-- Please refrain from discussing ANY sort of legislation --

Estate Planning IS intended for when a person IS "dead."
  • People can (and do) plan to have large IRAs inherited by their children, to be withdrawn based on current law.
  • From strictly a planning perspective, how is this plan above impacted if options 2-3 are not available ? Would you care ?

Code: Select all

4 Options for Non-Spouse Beneficiaries of Inherited IRAs

Option #1 - Cash Out the IRA Over 5 Years.
Option #2 - Take Out Required Minimum Distributions Over Your Life Expectancy.
Option #3 - Take Out Required Minimum Distributions Over the Account Owner's Remaining Life Expectancy.
Option #4 - Cash Out the IRA Account Immediately.
Lets also be pragmatic here and discourage anyone from burying their heads in the sand.
Landy,

You're kidding, of course?

What a travesty! That my heirs should be required to cash out their inherited IRAs rather than default on their student loans?

Only in America.

Keith
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Re: RMD and the tax trap

Post by LadyGeek »

The Forbes article How Retirees Pay Zero Taxes is a restart of a previously locked thread (non-actionable). See: Forbes Story How Retirees Pay Zero Taxes. This thread has run its course and gone off-topic. Between them, let's call this thread locked. See: Forum Policy

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Re: RMD and the tax trap

Post by LadyGeek »

After receiving a PM, I'm unlocking the thread. The intent is not about the locked topic (avoiding taxes), but when and how to take RMD distributions from an IRA.
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Re: RMD and the tax trap

Post by pastafarian »

Rick Ferri wrote:I've always been interested in the increasing tax burden that retirees with large IRAs have as the age and required minimum distribution (RMD) amounts increase...Some people are definitely going have a tax surprise when they reach their golden years.
I became aware of the potential surprise last year. With that in mind, we're using current cash flow (debt free) to pay the tax for Roth conversions while maxing out my Roth 401(k). The Optimal Retirement Planner revealed some nasty surprises with the taxes incurred for Roth conversions between age 65 and 70.
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Re: RMD and the tax trap

Post by fdeanw »

For retirees in high brackets facing a substantial RMD upon turning 70 1/2, would it generally make sense to take advantage of the rule that allows you to defer the first RMD until April of the year after you turn 70 1/2, and then to convert an equivalent amount from your IRA to a Roth IRA in the year that you turn 70 1/2? Unless doubling up on your RMDs in that second year is going to push you into a higher bracket than otherwise, it would seem that this strategy would always result in a lower taxation on the amount converted than if you had just taken the RMD in that first year.
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Re: RMD and the tax trap

Post by Alan S. »

fdeanw wrote:For retirees in high brackets facing a substantial RMD upon turning 70 1/2, would it generally make sense to take advantage of the rule that allows you to defer the first RMD until April of the year after you turn 70 1/2, and then to convert an equivalent amount from your IRA to a Roth IRA in the year that you turn 70 1/2? Unless doubling up on your RMDs in that second year is going to push you into a higher bracket than otherwise, it would seem that this strategy would always result in a lower taxation on the amount converted than if you had just taken the RMD in that first year.
You can't convert and NOT take your RMD in the first distribution year. Because it's an RMD distribution year, you must take your RMD prior to converting additional amounts if you choose. If you just convert in that year, the conversion is credited against your RMD and the amount of the RMD going into the Roth is an excess Roth contribution and must be removed.

That said, due to the taxation structure on SS benefits, it may turn out that if you defer your first RMD and take therefore take out 2 RMDs in the second distribution, you might may a lower tax total tax bill in those two years if you largely escape SS taxation in the first year. Once RMDs begin, you are also taking your SS benefits, so conversion opportunities from then on are usually limited to incremental conversions in years where your deductions (eg charitable or medical) allow you to claim large itemized deductions. But generalizations are dangerous since there are many variables based on size of the RMD, basis in the retirement plans, size of SS benefits and variations in itemized deductions and/or income spikes. It's best to analyze each year's situation late in the year when you have a good idea of your taxable income and deductions for the year and you can input various conversion amounts into Taxcaster or other software available to you. Finally, you will still have several months for the "do over" of recharacterized conversions if you change your mind, your conversion loses money etc.
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