Required Minimum Distributions from IRAs can create a Tax Problem in Retirement
You can spend decades doing the “right” thing—saving consistently in your 401(k), taking advantage of tax deductions, and building a substantial retirement account.
But there’s a potential problem that many people don’t think about until much later:
Eventually, the IRS requires you to take money out of those accounts—even if you don’t need the income.
These withdrawals are called Required Minimum Distributions, or RMDs, and they can create a significant tax bill later in retirement.
For Connecticut retirees, there’s another layer to consider: Connecticut income taxes can also apply to taxable retirement income.
Let’s look at a hypothetical couple to see how this can play out.
A $800,000 Retirement Account Today Could Become a Much Larger Tax Problem
Imagine a married couple, both age 55.
They each have $400,000 in a traditional 401(k), giving them a combined $800,000 in pre-tax retirement savings.
They plan to continue working and saving until age 67.
Their current household income includes:
$124,000 of salary income
$52,000 of additional income from side work
About $12,000 per year going toward retirement savings
For this example, let's assume their 401(k) investments continue to grow over time in a diversified portfolio.
The important point isn't whether the investment returns are exactly what we assume.
The important point is what happens when a large amount of pre-tax money eventually has to come out of those accounts.
The Problem With Pre-Tax Retirement Accounts
Traditional 401(k)s and IRAs can be excellent retirement-saving tools because you generally receive a tax deduction when you contribute, and the money can grow tax-deferred.
But there's a tradeoff.
You haven't paid income tax on that money yet.
Eventually, the government wants its share.
Under current law, RMDs generally begin at age 75 for people born in 1960 or later.
The amount you're required to withdraw is based primarily on your account balance and IRS life-expectancy factors.
For our hypothetical couple, that could mean substantial taxable income later in retirement.
Here's where things get interesting.
At age 75, their projected RMDs could be around:
$182,000
And that isn't necessarily the end of the story.
As their account balances and RMD percentages change, the required withdrawals can continue to increase.
Later in retirement, the model shows RMDs approaching $700,000 per year.
That's a lot of taxable income.
And remember: they may not actually need to spend all of that money.
The government is essentially forcing money out of their tax-deferred accounts and adding it to their taxable income.
RMDs Can Push You Into a Higher Tax Bracket
This is where retirement tax planning becomes important.
While they're working, our hypothetical couple may be in a relatively manageable federal tax bracket.
But later in retirement, their RMDs are added on top of other sources of income, such as:
Social Security
Pension income
Investment income
Part-time work
Other retirement accounts
That can push their taxable income significantly higher.
In our example, the couple eventually moves into the 24% federal tax bracket because of the income created by their RMDs.
And for Connecticut residents, there can be an additional state income tax consideration.
So the issue isn't simply:
“How much money do I have saved for retirement?”
A better question is:
“How much of my retirement savings will I actually get to keep after taxes?”
The Opportunity: Use Lower Tax Brackets Earlier
This is where a strategy such as Roth conversions can potentially become valuable.
Instead of waiting until RMDs force large amounts of money out of the 401(k), the couple could potentially convert portions of their pre-tax retirement accounts to Roth accounts during years when their taxable income is lower.
The idea isn't necessarily to convert everything at once.
Instead, the strategy can be to fill up lower tax brackets intentionally over several years.
In this example, we modeled a strategy designed to make use of the 22% federal tax bracket during the years before RMDs begin.
That creates a tax bill today.
But that's the point.
You're essentially choosing to pay some tax on your own terms, rather than potentially being forced to recognize much larger amounts of taxable income later.
What Happens to Their Future RMDs?
This is where the case study gets interesting.
Without proactive tax planning, the projected RMDs eventually become very large.
With the Roth conversion strategy, the projected RMDs are dramatically reduced.
Instead of having RMDs of roughly $182,000 at the beginning of the RMD period, the modeled withdrawals fall to much smaller amounts.
Over time, the strategy can potentially reduce the RMDs to approximately:
$40,000
$35,000
And eventually $0 of taxable RMDs
The exact results would obviously depend on investment returns, future tax laws, account balances, withdrawals and other assumptions.
But the concept is important.
You don't necessarily have to wait until age 75 to start dealing with your future RMDs.
The Goal Isn't Always to Pay Less Tax Today
This is an important distinction.
A Roth conversion doesn't magically eliminate taxes.
In fact, converting money from a traditional 401(k) or IRA to a Roth generally creates taxable income in the year of the conversion.
The planning question is:
Would you rather pay some tax now at a potentially lower rate, or risk paying more later when RMDs and other income could push you into a higher tax bracket?
That's a much more useful question than simply asking whether Roth conversions are “good” or “bad.”
What About Connecticut Taxes?
For Connecticut residents, the analysis can become even more important because federal taxes aren't the only consideration.
Connecticut generally taxes income from traditional retirement accounts, although the state's rules include specific exemptions and deductions that can affect how much retirement income is actually subject to Connecticut income tax.
That's why a retirement tax strategy shouldn't look only at your federal tax bracket.
Your state of residence matters, too.
Someone retiring in Connecticut may have a very different tax situation from someone with the same retirement accounts who moves to another state.
The Bigger Retirement Planning Lesson
This case study highlights something I see as an important part of retirement planning:
Building a large retirement account is only half the job.
You also need to think about how and when you'll eventually take the money out.
A successful retirement income strategy may involve coordinating:
401(k) and IRA withdrawals
Roth conversions
Social Security
Pension income
Capital gains
Medicare premiums
Connecticut income taxes
Charitable giving
Estate planning
Required minimum distributions
The goal isn't necessarily to eliminate your tax bill.
The goal is to have more control over when and how you pay it.
Don't Wait Until RMDs Begin
If you're in your 50s or 60s and have accumulated a substantial amount in traditional 401(k)s or IRAs, your RMDs may still be many years away.
That can actually be an advantage.
You have time to look at your projected retirement income and ask:
“What will my tax situation look like 10, 20, or 30 years from now?”
You may have opportunities today that won't be available once large RMDs begin.
And that's why retirement tax planning should happen before you retire—not after the tax bill arrives.
About the Author
Marc Lowe, CFP® is a fee-only fiduciary advisor based in Waterford, CT, helping small business owners & families make smarter financial decisions.
The information presented in this article is the opinion of the author and does not reflect the views of any other person or entity unless specified. The information provided is believed to be reliable and obtained from reliable sources, but no liability is accepted for inaccuracies. The information provided is for informational purposes and should not be construed as advice. Advisory services offered through In The Money Retirement, an investment adviser registered with the state of Connecticut. The information linked to on third-party sites is being provided strictly as a courtesy and convenience. We make no representation as to the completeness or accuracy of information provided at these websites. When you access these websites, you are leaving our website and assume any and all responsibility and risk for use of the web sites you are visiting. The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Comments