Key Takeaways
It seems counterintuitive to start taking money out of retirement savings before you need it. But there are good reasons for doing so.
Delaying distributions until the mandatory age of 73 may lead to larger RMDs, higher taxes, increased Medicare premiums, and potential tax burdens for heirs.
Taking RMDs before age 73 can reduce income spikes and help balance your tax liability throughout retirement.
As the old saying goes: “Good things come to those who wait.” But when it comes to retirement planning, that’s not always the case.
Consider the required minimum distributions (RMDs) you must start taking from your retirement accounts when you reach age 73. After all those years of diligent saving, the government makes you start taking some of that money out every year whether you need it or not. Many retirees prefer to delay their distributions until they’re absolutely necessary. That’s logical. Why take money out of an account that’s growing tax-deferred and pay taxes on it when you might not need the money? It may seem counterintuitive to start taking money out of retirement savings before 73 if you have other good sources of income. But doing so can cause you to have a massive spike in income later in life and, in-turn, pay higher Medicare costs and taxes.
The problem lies with the different types of income you expect to receive in your golden years. You may be receiving a pension at age 62 or 65. You will have to start taking Social Security benefits no later than age 70 on top of the RMDs from retirement accounts by age 73. If you’re retired, it’s nearly impossible to defer this income to a later date. If you’re only taking your minimum distribution amount from your account, you’ll only need to take down 3.77% of your account balance the first year. However, the percentage you’ll need to distribute to yourself gets progressively higher each year. And the double whammy is that your IRA will continue to grow as you age and lead to larger distributions later in life.
Like many retirees, you have different accounts with different tax structures such as IRAs, 401(k)s, SEPs and brokerage accounts. If you don’t have a plan in place, you could be making mistakes from a tax, estate and legacy perspective when it comes to how you structure your distributions and from which account. One of the most frequent questions new clients ask us is: “Where is my money going to come from?”
If you’re still on the fence about whether to use a financial advisor, this is a pretty good reason to do so. RMD planning one of the areas we spend the most time on with our clients.
A JP Morgan Chase study found that 80% of those younger than RMD age were not taking withdrawals from their retirement accounts. And about 84% of those subject to RMDs took only the required amount. They’re doing themselves a disservice with that approach, especially if they’re delaying Social Security until age 70.
Let's say you retire at 65 and you’re just using your brokerage account for living expenses. Your taxes are going to be very low at that point. But when you reach age 73, you’re now receiving taxable income from multiple sources including retirement account RMDs, Social security at the maximum level, and possibly a pension in addition to your brokerage account. Your adjusted gross income and hence, tax liability (federal and often state) could explode later in life. Under these circumstances, you can't defer anything, because these are all required sources of income you must start taking. Not only are income taxes much higher, but you’ll also have to pay more in Medicare premiums, which are indexed to adjusted gross income. Further, you might be forced to pay higher capital gains taxes when you sell appreciated stocks or other assets from your brokerage account.
Solution
Consider taking RMDs from your retirement accounts well before age 73 to even out your tax liability. I know we’ve been trained all our lives to maximize savings, but you must always look at your decisions from an after-tax perspective. Again, letting your IRA continue to grow seems like the right thing to do. But, if you pass away with a large IRA, your surviving spouse (who must now start filing single), could be left with a big RMD to take. And if you have no surviving spouse, then it’s your children who will inherit that IRA and will have to start taking distributions from that account. Thanks to recent legislation, your kids can only stretch those distribution over 10 years instead of indefinitely. That means they’ll have to pay tax on that income when they’re likely in their prime earning (i.e. high taxable income) years. Their RMDs from an inherited IRA could inadvertently push them into a higher tax bracket.
At Novi, our philosophy is to ensure that clients have an even and structured tax experience over their entire retirement. We don't want them taking money exclusively from a brokerage account and paying 1% effectively in taxes in the early years of retirement and then 25% or 30% at the end of retirement. We’d rather see them pay 15% to 20% throughout their entire retirement. It starts with taking RMDs much earlier than age 73. There are multiple ways to make that happen which I can discuss in more detail if you reach out to me. There’s no one-size-fits-all solution. But a broad approach is that while your income is low, we want to take advantage of reducing your retirement account balances.
Real-World Example
We started working with a 50-something couple looking to retire in their mid-60s. Both had successful careers and had amassed sizable 401(k)s and some small pensions. Due to their work history, they each expected to receive considerable Social Security benefits as well. While getting to know them, they told us how they planned to cover their living expenses up until age 70 (when they’d want to start taking Social Security) with cash saved from the recent sale of a vacation home. Their logic was they had the cash so why not use it? They figured the proceeds from the vacation home sale would preclude the need to tap into Social Security and retirements accounts early. Just one problem: By waiting until age 73 their annual IRA distributions would start at around $150,000 a year. Combined with Social Security and their pension, they were looking at a very high taxable income in their later retirement years.
Fortunately, we had time to plan and showed them several strategies to avoid these mammoth IRA distributions and reduce their taxes and other costs later in retirement. This approach saved them tens of thousands of dollars and ensured that they (and their children) kept more money in their pockets.
Conclusion
If you or someone close to you has questions about your retirement plan or required minimum distribution, please don’t hesitate to reach out. We have the knowledge and education to look at RMD planning as part of our holistic process.
RYAN A. DUNN, CFP®, is a Wealth Manager at Novi Wealth
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