Recently, I was sitting with a client celebrating the fact that her IRA balance is nearing $1 million dollars. This is always an exciting milestone. I rang the bell for her.
In 2023 my client will turn 72 and she will need to take a distribution from her IRA.
The distributions are called Required Minimum Distributions. (RMDs)
RMDs must also be taken from employer retirement accounts such as 401k/403b plans starting at age 72.* The starting age was recently changed, it used to be 70.5
The amount that must be distributed is based on a calculation – more on that below.
Why does the government require these distributions? Because in most cases the dollars contributed to the IRA were never taxed. All of the dividends/interest and investment growth have not been taxed. Eventually Uncle Sam wants some moolah!
These distributions are taxable as ordinary income on the Federal level. Ordinary income rates top out at 37% depending on total income. State taxability varies, but in Massachusetts the distributions are also taxable.
How much does my client have to take next year?
We won’t know exactly until 12/31/22. This year 12/31 is on a Saturday, so it will be based on the 12/30/22 balance.
To calculate her Required Minimum Distribution we take the 12/30/22 balance – let’s say it is exactly $1,000,000.00.
Next we look at the Uniform Lifetime Table** from the IRS to determine her divisor.
She will turn 72 before the end of 2023, so her divisor is 27.4
We divide the year-end balance, $1,000,000 by 27.4.
The result is $36,496.35.***this must be distributed by 12/31/2023.****
This is all taxable income. She is not very happy about this.
Why? In all likelihood she will not need $36K+ in 2023 (thanks to multiple other sources of cash flow). She’s annoyed about paying a tax bill on a distribution she does not need.
First of all we file this under ‘Not a bad problem to have’.
So what are her options?
Don’t take the Required Minimum Distribution
Terrible idea, as the penalty for not taking an RMD is 50% of the distribution. (Over $18K in her case)
Pro Tip: If you legitimately overlooked your RMD (a ‘reasonable error’ in IRS parlance) you can submit a penalty waiver request to the IRS. In my experience a one-time penalty waiver request has always been granted.
Do a Qualified Charitable Distribution
She can do a Qualified Charitable Distribution (QCD) for some/all of the RMD. To do this, the IRA custodian sends a check directly to the charity of her choice. This is a terrific way to give to causes you care about and save on tax at the same time.
The QCD amount is not taxed.
You do not need to itemize deductions to get this tax break making it an especially good option for taxpayers taking the standard deduction.
You can’t do a QCD from an employer plan such as a 401k. Only an IRA.
Pro Tip: The tax form (1099-R) you receive from the IRA custodian at the end of the year does NOT indicate how much if any went to charity. You must keep track and notify your tax preparer of the amount that was a QCD. You should then double check your return to make sure it was reported accurately.
There is one loophole, but only for employer plans such as a 401k. If you are still working for the company that sponsors your 401k, then you do not have to take an RMD from that 401k plan.
This does not apply to previous employer 401k plans or IRAs.
The loophole does not work if you are a greater than 5% owner of the company sponsoring the 401k plan
Pro Tip: In certain cases it’s possible to ‘roll-in’ previous employer 401k plans and/or IRAs to a current employer’s 401k plan. Whether it’s possible or desirable requires due diligence.
Take the distribution, pay the tax, and invest the difference.
Often this is the answer.
The easiest way to pay the tax is to have it withheld from the distribution, similar to how taxes were withheld from your paycheck during your working life.
If you don’t need the amount left over after tax withholding you can reinvest it. This is done in a brokerage account. You can invest in any investment vehicle you want! The money continues to work for you. Future tax is limited to the tax on interest/dividends.
When you sell you owe capital gains tax on the gain only. Capital gain tax rates are lower than ordinary income tax rates.
Invest your IRA in slower-growing assets
One trick to reducing RMDs is investing the IRA in slower-growing assets, such as bonds.
This technique is known as asset location and only works if your portfolio includes different kinds of accounts such as Roth IRA and/or non-retirement plan brokerage accounts in addition to your IRA.
Asset location exploits the varying tax attributes of these different account types to maximize after-tax return.