Did you get your taxes done on time?  Good for you!

It seems each year many of us scramble to get our taxes done while searching for ways to reduce our previous year’s federal income tax.

Whether doing your own taxes with the assistance of an online preparation service like TurboTax, or working with a tax professional, you may have been advised to contribute to a qualified plan like an IRA in order to minimize your previous year’s taxes.

It Seems Like Good Advice.

Save money for retirement, and save taxes, right?

Are you are really saving money on taxes though? While you do receive a deduction on your previous year’s taxes, where do they go? Do they vanish forever, or will they come back to bite you later?

Contrary to belief, taxes aren’t being saved; they’re being deferred. You’re actually kicking the can down the road to another day and time. You are receiving a deduction on a small contribution. Those taxes are deferred until you withdrawal them for later use in retirement. Hopefully you are able to grow that money to a larger sum over time through investing.

The Seed Or The Harvest?

I come from an agricultural background. Therefore, I’ll draw on my experience on the farm to demonstrate how tax deferral really works. Imagine a farmer harvested a seed corn last fall. He sold some, and consumed some for his livelihood. He also gave some to the government. Their share equates to taxes!

However, the government runs a program that will permit him to “save some kernels” from their share of the harvest. It is to be used the following year towards building a prosperous future for the farmer. One kernel produces a single corn plant. That plant may produce several ears of corn each containing upwards of 800 kernels. This is like investing your tax-deferred IRA money with one exception. Corn reproduces at a much higher percentage than what is reasonable to expect from a dollar invested.

Instead of consuming all of his kernels, the farmer holds some back to produce more. Eventually he can amass a sizable stockpile of corn seed in his storage facilities.

Eventually however, he’ll begin consuming the stockpiled kernels, making withdrawals to sustain himself, and his livelihood. What happens to the farmer’s deferred liability to the government when he begins to make distributions from his stockpile?

That’s when the taxman returns with his hand out. Unfortunately for the farmer, he has no say in what percentage of the distribution the government’s share is. In fact, its quite possible the government’s share may have increased since the time when he deferred the liability.

Does it make more sense to pay taxes on the seed at a known historically low rate, or rather on the entire crop harvest at an unknown rate?

Considering tax rates are historically low and the federal budget is historically high, will you be in a higher tax bracket later and end up paying more?

The Day Of Reckoning: Age 70 ½

The deferment of your taxes means lost revenue for the federal government today. Therefore they’re only willing to let you defer your liability for so long. Eventually, you must make distributions.

These forced distributions from your qualified plans are known as Required Minimum Distribution, or RMDs. RMD rules apply to both IRAs, and employer sponsored pans like 401(k)s. However, the rules determining when you must begin taking RMDs very slightly depending on the type of tax-qualified plan.

For the purposes of this article we’ll focus on traditional individual retirement arrangements better known as IRAs, but the general rules discussed apply to all qualified plans except Roth IRAs which do not require withdrawals be made while the original owner is still alive.

RMDs are the minimum withdrawal required, not the maximum that must be withdrawn from your IRA each year. RMDs are calculated by dividing the distribution period associated with your age into the December 31 value of your IRA. For most, your required minimum distributions will begin the year you attain age 70 1/2.

However, it is possible that you must take a required minimum distribution prior to 70 1/2 if you are the beneficiary of an inherited IRA or Roth IRA (RMD rules do apply to Roth IRAs after the original owner has passed).

How Are RMDs Calculated?

The distribution period at age 70 ½ is 27.4. It’s a divisor, not a percentage of your account value. You divide the distribution period into your previous year’s December 31st account value in order to determine your RMD. If your December 31st value of your IRA were $100,000 your RMD would be $3,649.64 (100,000/27.4=3,649.635)

If you own multiple IRA accounts, you are permitted to combine all of the account values together in aggregate to determine your RMD, and then allowed to take the RMD strategically from one account or more than account. In other words, you are not required to take an equal portion RMD from each account. This does provide some flexibility when it comes to saving and investing and determining which savings and investments to liquidate, and which to hold when making an RMD for any specific year.

On the other hand, RMDs from 401(k)s or other employer sponsored retirement plans must be calculated and withdrawn from each individual account.

3 IRAs & One RMD

For example, imagine you have separate 3 IRAs.

  1. The first IRA is in a bank money market account with a previous year’s December 31st value of $30,000 earning 1.0% annually.
  2. The 2nd IRA is in a brokerage account holding investable securities like stocks and bonds with a current market value of $100,000, but a previous year’s December 31st value of $130,000. In other words, the market value is less now than it was at the end of the previous year due to negative market fluctuations.
  3. Finally a 3rd IRA is in a fixed interest rate annuity earning 3.0% annually with a previous year’s December 31st value of $100,000. It is designated specifically for protecting against outliving your income. A known specific level of lifetime income to compliment social security will begin at age 75.  So long as no withdrawals are made prior to the commencement of the income stream you will know exactly how much annual income may be expected for the remainder of your life.

Now imagine you turned 70 ½ and are required to make a distribution. The total December 31st value of all of your IRAs is $260,000 ($30,000 +$130,000+$100,000 = $260,000).  Your RMD is equal to $260,000 divided by 27.4, or $9,489. You could take the entire withdrawal from the bank money market in order to avoid selling marketable securities at a loss, or disrupting the planned future income stream from the annuity.

Now imagine you have a 401(k) from you previous employer, and you did not roll it over to an IRA. Its December 31st value was $100,000, but due to market fluctuation it is worth less today than it was then. Because it is treated differently than an IRA you are not permitted to make a distribution from the Money Market to satisfy the RMD. The RMD must be calculated and withdrawn from the 401(k) specifically. 

What’s The Consequence For Failing To Comply?

There’s a steep penalty for failure to comply with RMD rules.  Missing an RMD deadline results in a 50% penalty. In other words, you’ll still have to take your required withdraw, but you pay a 50% tax on the distribution. You’ll have to give half of your distribution to the federal government for making a relatively simple accounting error. Therefore it is critical that you do not fail to make your required minimum distributions from your IRA.

How Might RMDs Impact Social Security Benefits

Distributions from IRAs are taxed as regular income. Treated as regular income, large RMDs could bump you into the next highest marginal tax bracket. This may cause your next taxable dollar to be taxed at a higher rate. Controlling taxes throughout retirement can be a challenge for many retirees, and RMDs can compound the problem.

By age 70 1/2, anyone who is eligible for Social Security benefits should be receiving them, as there is no benefit to delaying beyond age 70. RMDs treated as regular income are added to Provisional Income, which is the calculation used to determine whether you pay taxes on your Social Security benefits. Large RMDs may increase the portion of your Social Security benefits that are subject to taxation at your next marginal highest tax bracket.

So What May Be Done About It?

We’d suggest planning ahead and working with a tax planner, not a tax preparer. What’s the difference? A tax planner looks forward to the future when advising clients on taxes, and a tax preparer looks backwards to determine how to “save” taxes last year.

Rather than kicking the can down the road and being forced to take distributions when they may adversely affect your retirement income, it might be wise to strategically manage your distributions prior to age 70 1/2.

Roth conversions are another consideration. Converting some of your forever-taxed money to never-taxed money may minimize the impact of RMDs in retirement. Roth IRA distributions are income tax free, and they are not counted towards your provisional income. Therefore, they will not adversely affect the taxation of your Social Security benefits. Converting some of your traditional IRA funds to Roth IRA prior to age 70 1/2 within a well-organized tax plan might make sense.

Consult a tax planning professional before making any decisions regarding taxes.

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