September 2024 Planning Insights

For the next several months we will take a break from providing general market commentary and instead provide several Guides on financial topics that may be pertinent to your financial picture. This September 2024 edition addresses two related topics:

• Strategies for Reducing Taxes on IRA Required Minimum Distributions (RMDs)
  and

• Converting a Traditional IRA to a ROTH IRA

Strategies for Reducing Taxes on Required Minimum Distributions (RMDs)

The tax you will pay on Retirement Account RMDs is an important cost to factor into a long term retirement plan. IRA distributions are considered ordinary income and as a result can push you into a higher tax bracket. Here are a few strategies to potentially reduce your RMD tax during retirement.

1.    Start withdrawals sooner to maintain a lower tax bracket in later years
Once you reach age 59 1/2, you can begin taking distributions from retirement accounts without penalty. Many retirees hold off taking distributions until their RMD age (currently 73 if born before 1960, 75 if born in 1960 or later). On one hand, delaying withdrawals can help retirement account assets continue to grow. However, as the following tables show, delaying distributions may also push you into a higher tax bracket in your later retirement years. If you expect to continue to have consistent non-investment income in your retirement years, this strategy is worth taking a closer look at with your tax advisor.

Minimizing RMDs

Scenario 1 | Without pre-RMD withdrawals

Without pre-RMD withdrawals, RMDs push this investor into the 32% tax bracket in retirement.

Scenario 2 | With pre-RMD withdrawals

Making annual withdrawals prior to RMD age, up to the limit of the 24% tax bracket, helps keep the investor out of the 32% tax bracket in retirement.

Source: Schwab Center for Financial Research.

Calculations assume a married couple with $230,000 in combined taxable income and $2.5 million in combined tax-deferred accounts at age 65. Annual growth of 6% is added to the account balance at the end of each year, and nonportfolio income and tax brackets increase by 2% annually to account for inflation. Nonportfolio income may include business income, pension payments, rental income, Social Security benefits, etc. This hypothetical example is only for illustrative purposes. Tax changes and income fluctuations may negatively affect the outcome of this strategy.

Your expected income during retirement years, and the resulting tax brackets, will be the key determinants of the efficacy of this strategy. Again, consult your tax advisor to review different scenarios. 

2. Make qualified charitable distributions (QCDs)
You can donate up to $100,000 per year directly from your IRA to qualified charities. This counts toward your RMD but is not taxed as income. QCDs are a great way to give to charities you had planned to support without tapping into your non-RMD income. You have to be 70 ½ or older to make an eligible QCD.

3. Consider a qualified longevity annuity contract (QLAC)
You can use up to $200,000 from your IRA to purchase a QLAC, which provides guaranteed income later in life. The QLAC amount is excluded from RMD calculations. QLACs are the only way to buy an annuity with pre-tax money that pays out guaranteed income at a later date. Tax is paid on the annuity distributions rather than the RMD.

4. Keep working past age 73
If you're still employed, you may be able to delay RMDs from your current employer's 401(k) plan until you retire. Unfortunately, this only works for your 401(k) at your current employer.  

5. Donate your RMD to a 529 college savings plan
While this doesn't reduce taxes directly, it can be a tax-efficient way to save for education expenses that you had already planned to spend. RMDs are taxable distributions, but if you put RMD money into a 529 Plan, the money grows tax-deferred and can be withdrawn tax-free for educational expenses. You can also take the RMD from one account and put it into multiple 529s. If given to a parent or student 529 account, withdrawals for education expenses don’t count as income and are not taxed.

Should I convert my IRA to a ROTH?

Do you have a traditional or SEP IRA and have wondered if a ROTH IRA might be a better choice into your retirement years? If so, you’re not alone. This can be a confusing topic and the strategy has several pro’s and con’s.

First, let’s look at how the 2 types of retirement accounts differ. The fundamental difference is in how contributions and withdrawals are treated by Uncle Sam. Contributions to traditional IRAs are with pre-tax dollars, thus reducing your taxable income in the year you contribute; withdrawals are taxed at your modified gross income tax (MAGI) rate at the time of withdrawal (minimum age to withdraw without penalty is 59 ½).  The IRS currently requires you to withdraw a minimum amount (the RMD) starting no later than age 73 (75 for those born in 1960 or later). RMD amounts increase each year based on an IRS life-expectancy table. If you don’t withdraw the full amount each year before the deadline, then a steep penalty is assessed: 25% of the amount not taken.

Contributions to ROTH accounts, on the other hand, are in dollars you already paid tax on, and withdrawals are not taxed including earnings on the contributions. The ROTH IRA has a 5-year holding period, so this needs to be factored into your retirement funding.

So why consider converting to a ROTH?

Apart from tax-free withdrawals on earnings, there is no required minimum distribution (RMD), allowing your assets to continue to grow if you don’t need to tap them. This gives you full flexibility on how much you can withdraw and when, starting from age 59 ½ (and assuming your ROTH is more than 5 years old). You also can continue to make contributions to the ROTH, though the limits are low ($7-8K) and restricted further by MAGI limits.

The negative of converting to a ROTH – especially from a large IRA – is you may be required to pay the top marginal tax rate of 37% on most or all of the entire conversion amount (the conversion amount is added to your total taxable income). Unless it’s a year of high income where you can afford to pay the tax all at once, this may not be the best strategy.

Alternatively, however, converting your IRA gradually can spread the increase in income over several years and avoid subjecting it to the top marginal tax rate. Spreading conversions over multiple years often makes the most financial sense for larger IRAs. This can help reduce the tax owed each year by potentially keeping you in a lower tax bracket.

It’s also important to consider when you’ll need to withdraw funds from your Roth IRA. As mentioned, funds can’t be withdrawn without penalty within five years of the conversion. If you convert your IRA to a Roth gradually over time, those conversions each re-trigger the five-year rule for that portion of the money. So you would need to keep track of how much was converted each year and when the 5-year period for each conversion ends.
Once again, your expected income and tax rate during retirement will be a key determinants on whether converting to a ROTH makes sense. Consult a tax advisor who can take you through different income and tax scenarios to determine what approach makes best sense for you.

Sources: IRS, Smart Asset, Perplexity AI

Disclaimer

The information presented in this document has been obtained from or based upon sources believed by Atlas Financial Advisors, LLC (“Atlas”) to be reliable, but Atlas does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising out of errors, omissions or changes or from the use of information presented in this document. This material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a limited view. Any headings are for convenience of reference only and shall not be deemed to modify or influence the interpretation of the information contained.

This information is not investment research or a research recommendation, as it does not constitute substantive research or analysis. It is provided for informational purposes and does not constitute an invitation or offer to subscribe for or purchase any of the products mentioned. This document is not to be relied upon in substitution for the exercise of independent judgment.

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