The Secure Act 2.0 increases the mandatory starting age of required minimum distributions from 72 to 73 this year, and will boost it to 75 in 2033. Investors born between 1951 and 1959 must start RMDs by 73. Those born in 1960 or later must commence RMDs by 75. This year’s increase comes just three years after the original Secure Act pushed back the age requirement from 70 ½ to 72.
Raising the age that investors must begin taking RMDs expands planning opportunities for financial advisors to help clients grow their wealth, save on taxes, and fund their retirements. People are living a lot longer today and delaying RMDs can help qualified accounts last a lifetime. But while there are positives, there are also some potential negative consequences which I’ll explain, too.
The benefits of delayed RMDs
Boosting the RMD age allows investors to grow their retirement accounts for longer. Those born in 1960 or later can enjoy 4.5 years of additional tax-deferred growth than what was recently possible for retirees. This will help clients lessen the risk of outliving their money and increase the odds that these accounts will last until age 95 or 100. It could also increase the chance that your clients will have funds leftover to leave to their heirs.
More growth, more taxes
Of course, growing a traditional IRA or 401(k) for longer will mean higher taxes down the road. RMDs are age-based and reflect life expectancy. At age 75, a divisor of 24.6 distribution years means an RMD will be about 4.06% of the account value as of December 31 of the previous year. On a $1 million IRA, your RMD would be $40,650 at age 75. Each year, the divisor becomes smaller and the percentage of RMD increases. At age 76, the divisor is 23.7 or approximately 4.22%. RMDs were reduced last year when the IRS adopted new life-expectancy tables.
Most people look to reduce their taxes in the current year, but may not think about their total taxes over the next 10 or 20 years. And many tax preparers aren’t showing their clients a bigger picture than the current tax return. So, my concern is that many investors will happily defer to age 75 and then face larger taxes, with no flexibility to do anything about RMDs at that point.
Many retirees are shocked by how much they pay in taxes between RMDs, Social Security (85% taxable for most of my clients), pensions and other passive income. Investors who delay claiming RMDs for an extra 4.5 years, and have hypothetical returns of 7% a year, would see their IRA grow from $1,000,000 to $1,355,000. That’s great for retirement savings, but is also yields another $355,000 that your client (or their heirs) will eventually have to pay taxes on.
Tax bracket ramp-up
While an investor could just ignore their IRA until age 75, it may be smarter to take distributions before age 75 to reduce future tax bills. Let’s say your client retires at age 65, and lives off their savings and interest until they start Social Security at age 70. Let’s also assume they further delay IRA distributions until age 75. While your client has succeeded in keeping their current tax bills as low as possible, they have also given up an opportunity to pay taxes at a very low rate.
How? For 2023, a married couple with taxable income up to $89,450 is in the 12% tax bracket. Add back a standard deduction of $30,700 (for a couple age 65 or older), and you could have a gross income of up to $120,150 and pay only 12% federal taxes.
At 65, the hypothetical couple may have very low taxable income, let’s say $20,000 from interest. At age 70, they add $55,000 in taxable Social Security benefits, and then at age 75 they have another $50,000 in RMDs. Although their spending did not increase, their gross income rose from $20,000 to $125,000. Even worse, their taxable income, which was zero at 65, would put them in the 22% tax bracket at 75.
Expanded window for Roth conversions
The real opportunity for investors is not to delay RMDs to age 75, but to use the post-retirement years of low tax brackets to gradually convert money from their traditional accounts to a tax-free Roth IRA. When our couple was 65 and only had $20,000 in income, they had an opportunity that year to convert $100,000 from their traditional IRA to a Roth. And pay only 12% taxes on it.
Over the next 10 years, that $100,000 conversion would grow to $196,715 at a 7% return. By paying $12,000 in taxes upfront on the conversion, the couple could avoid paying 22% taxes on $196,715 in the future. Assuming they retired at 65, we now have a 10-year window to make annual Roth conversions and reduce future tax bills.
Roth accounts do not have RMDs. If one spouse passes, the surviving spouse can continue the tax-free growth of the Roth as long as they live. Or they can take income from the Roth tax-free. And then their kids can inherit the Roth account tax-free, too.
The original Secure Act abolished the stretch IRA. If your clients’ kids inherit their traditional IRA now, they must distribute the entire account in 10 years. And if they are in their prime working years, those kids could easily be paying a federal tax rate of 24% to 37%, plus another 3% to 12% in state income taxes. While IRA distributions are not subject to the 3.8% net-investment income tax, the IRA distributions could push the heirs’ “other income” above the income threshholds ($200,000 single, $250,000 married filing jointly).
It’s a lot of taxes. Heirs could potentially lose 40% or more of an inherited IRA to taxes. Leaving a $1 million or $2 million IRA to your kids is going to be very generous to Uncle Sam. By delaying RMDs to age 75, you might be reducing taxes for yourself but leaving it to your heirs to pay an even larger tax bill.
The widow’s tax bracket
The picture is much worse if one spouse dies. Let’s say our couple decides to delay RMDs as long as possible. Then the husband passes away at age 75. The surviving wife now inherits his IRA, and rolls it into her own IRA. She’s also 75, and now has to pay RMDs on both IRAs. The problem is that she is no longer married filing jointly — she’s now a single taxpayer.
For example, a married couple over 65 with gross income of $120,000 would owe only $10,276 in federal income taxes with the standard deduction. They would be at the top of the 12% bracket. The same $120,000 gross income for a single taxpayer over 65 would push the widow well into the 24% tax bracket, resulting in $25,565 in taxes due. Delaying the RMDs on a large IRA could be a very poor choice for a couple if it means future distributions will be received by a single taxpayer. The married tax rates are much more advantageous for taking distributions from an IRA, in terms of both the tax bracket and the doubled standard deduction.
Most Roth conversion calculations assume both spouses remain alive. Often this yields unimpressive tax savings. However, delaying RMDs could mean much, much higher taxes down the road for a single tax payer. That is a risk to consider.
When couples are newly retired and in good health, they might be assuming that they will both have a long lifespan. For couples with large IRAs, it is very important that we do not miss the window of low tax years to make Roth Conversions. Once those years are passed and they have begun Social Security, RMDs, or have become widowed, the taxes paid on a Roth Conversion will become significantly higher. Plus, the earlier we do a Roth Conversion, the more future years of tax-free growth can be obtained.
Now that investors can further delay RMDs, there is more potential for clients to generate out-sized IRAs. And with 100% of these accounts being taxable income, the eventual tax liability could be enormous. Even if your clients won’t turn 75 for years, don’t ignore their RMDs until then. In other words, don’t be like our government and kick the can down the road. Help your clients use their years of low income prior to RMDs to make Roth conversions or take distributions and shift funds out of the high-tax IRAs.
Delaying RMDs to 75 is an opportunity to lengthen years of compounding and create tax-diversification for yourself and your clients, Clients can choose to take distributions from traditional IRAs, tax-free Roths, or taxable capital gains. Think about how to minimize their taxes over 20 years and not just what will make their taxes as low as possible this year. Make sure to discuss with couples the impact of their RMDs if one of them should pass away.
Unfortunately, delaying RMDs is not a fix for America’s retirement problem. For example, participants over age 65 in Vanguard’s defined contribution plans have an average account balance of $279,997, but a median account balance of just $87,725. Although increasing the years of compounding to age 75 can help grow account balances, it will be most beneficial to those who already have $1 million in retirement accounts and can afford to delay withdrawals.
We still have to do a better job of getting workers to save early and save often.
Scott Stratton, CFPⓇ, CFA is the founder of Good Life Wealth Management, a Registered Investment Advisor in Hot Springs, Arkansas. You can reach Scott at firstname.lastname@example.org.