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Daniel Cullinane CPA p 848-250-9587
TAX EFFICIENT MINIMUM DISTRIBUTION
Individual retirement accounts are a popular and effective method of saving for retirement. For some individuals, however, there is a catch: starting at age 70½, account holders must make required minimum distributions, whether the money is needed or not. The authors provide several strategies to reduce the potential tax impact of these distributions, including conversion to Roth IRAs and the use of qualified charitable deductions.
For decades, seniors have been able to enroll in Medicare at age 65. Full retirement age for Social Security benefits has increased from 65 to 66 and is now on its way to 67. For many retirees, yet another age represents a financial milestone: 70½, when required minimum distributions (RMD) from pretax retirement accounts generally begin. Account owners can withdraw more, but not less, each year, whether the cash is needed or not, and withdrawals of pretax funds generally trigger income tax. Any shortfall is subject to a 50% penalty.
In practice, many individuals are reluctant to take RMDs and pay tax on money they don’t need. Savvy planning, however, can help reduce RMDs, and thus the resulting tax bill.
The June-July Divide
Because RMDs begin after age 70½, taxpayers born in the second half of the year get a full year’s deferral. Suppose, for example, that Joan was born in June 1947 and will thus reach 70½ in December 2017. Her neighbor Bill was born in July 1947, so he will reach 70½ in January 2018. The official required beginning date (RBD) for the RMDs is April 1 of the year after reaching 70½; therefore, Joan’s RBD is April 1, 2018, while Bill’s is April 1, 2019. This is true even if Joan was born at 11:59 p.m. on June 30 and Bill at 12:00 a.m. on July 1. Assuming that Joan does not need to take money from her IRA, her RMD is determined by the IRA’s balance on December 31, 2016 (in this example, $400,000). Then she goes to the IRS Uniform Lifetime Table, shown in the Exhibit, and looks for the distribution period for age 70, which is 27.4 years. By dividing her prior year-end IRA balance ($400,000) by the distribution period (27.4), Joan calculates that her RMD, which she must withdraw by April 1, 2018, is $14,599. (Note that taxpayers whose sole IRA beneficiary is a spouse who is more than 10 years younger can use the joint life expectancy tables in Publication 590, which provide somewhat smaller RMDs. Some IRA custodians will inform account owners of their RMD amounts after age 70½.)
Uniform Lifetime Table
[Age; Distribution Period; Age; Distribution Period 70; 27.4; 93; 9.6 71; 26.5; 94; 9.1 72; 25.6; 95; 8.6 73; 24.7; 96; 8.1 74; 23.8; 97; 7.6 75; 22.9; 98; 7.1 76; 22.0; 99; 6.7 77; 21.2; 100; 6.3 78; 20.3; 101; 5.9 79; 19.5; 102; 5.5 80; 18.7; 103; 5.2 81; 17.9; 104; 4.9 82; 17.1; 105; 4.5 83; 16.3; 106; 4.2 84; 15.5; 107; 3.9 85; 14.8; 108; 3.7 86; 14.1; 109; 3.4 87; 13.4; 110; 3.1 88; 12.7; 111; 2.9 89; 12.0; 112; 2.6 90; 11.4; 113; 2.4 91; 10.8; 114; 2.1 92; 10.2; ≥115; 1.9 Source: irs.gov]
Bill’s RBD is April 1, 2019, a year later than Joan’s, and his first RMD will be for 2018, based on his IRA balance on December 31, 2017. Assuming that he also has a $400,000 balance at that point, he will find that the age 71 distribution period, is 26.5 years. A shorter period means more money must come out, so Bill’s first RMD will be $15,094. If Bill withdraws $10,000 from his IRA no later than his RBD, he will be $5,094 short and owe a $2,547 penalty.
Going back to Joan, she will have another RMD deadline on December 31, 2018, barely nine months after her first RMD. This RMD will be based on her December 31, 2017, IRA balance, so she will use the age 71 distribution period. Going forward, she will have another RMD due each subsequent December for as long as she has money in her traditional IRA.
If Joan follows the schedule described here, she will have two RMDs in 2018, perhaps withdrawing around $30,000, which might push her into a higher tax bracket for the year. Therefore, seniors approaching their first RMD might consider taking that distribution by December 31 of the year they reach 70½, rather than waiting until the following April 1. Taking only one RMD might prevent one from moving into a higher tax bracket.
The above examples assume that the taxpayers have only one traditional IRA. Many seniors will have two or more such IRAs; if so, they must calculate the annual RMD for each one, at each year-end, and total the amounts. The RMD can come from any or all of these IRAs.
Suppose that Maria, age 73, has three traditional IRAs, with RMDs for 2017 of $1,000, $2,000, and $3,000, for a total of $6,000. Maria can withdraw that $6,000 from one of her IRAs, or a total of $6,000 from more than one IRA, in any manner she chooses. She might find it more convenient to deal with one IRA, or she may want to manage how much she keeps in the different accounts, if she has designated different beneficiaries.
Flexibility has its limits, however. Suppose Maria and her husband Darrell are both age 73, with traditional IRAs, and that in addition to Maria’s $6,000 2017 RMD, Darrell has a $10,000 RMD from his IRAs. Darrell can withdraw $16,000 from his IRAs and Maria can withdraw zero from hers, giving the couple the required $16,000, as reported on their joint tax return for 2017. In that respect, the IRS has not suffered a tax underpayment; however, the tax law requires each taxpayer to take RMDs from his or her Individual Retirement Account. Maria has a $6,000 shortfall for her 2017 RMD, so she will be subject to a $3,000 penalty.
Many seniors will have two or more such IRAs; if so, they must calculate the annual RMD for each one, at each year-end, and total the amounts.
Avoiding the After-tax Trap
Rather than underpaying tax on RMDs, some individuals will overpay their tax; this can be the result for IRA owners with after-tax as well as pre-tax money in their accounts. Often, high-income taxpayers make nondeductible contributions to traditional IRAs because they cannot make deductible contributions nor contribute to Roth IRAs. In 2017, for example, single taxpayers with modified adjusted gross income (MAGI) equal to or greater than $133,000 are shut out from Roth IRA contributions, while married couples filing jointly cannot contribute to a Roth IRA if they have MAGI of $196,000 or more. There are no income limits, however, for nondeductible contributions to traditional IRAs.
Errors can lead to paying tax twice on the same dollars. Suppose, for example, that Amal has $88,000 in his traditional IRA on November 15, 2017. In prior years, Amal has funded this IRA with pre-tax and after-tax dollars; assume that $35,000 came from nondeductible contributions, $25,000 from deductible contributions, and $28,000 from investment earnings inside the IRA.
Now Amal wants to take a $4,000 RMD from his IRA for 2017. If he reports $4,000 of taxable income from that distribution, he could wind up paying too much in taxes. Instead, distributions from such an IRA should be reported as including both pre-tax and after-tax dollars, proportionately. Here, the after-tax contributions must be compared with the year-end IRA balance, plus distributions during the year, to calculate the proper ratio.
Suppose that Amal’s IRA holds $95,000 on December 31, 2017; his $88,000 IRA was reduced by the $4,000 RMD during the year, but increased by investment earnings. Thus, Amal’s IRA balance for this calculation is $99,000: the $95,000 at year-end plus the $4,000 RMD. (This assumes no other distributions in 2017.) Dividing his $95,000 IRA balance into the $35,000 of after-tax money in this example yields 36.8% as the portion of his RMD representing after-tax dollars. Therefore, of Amal’s $4,000 distribution, $1,472 (36.8%) is a tax-free return of after-tax dollars, while the balance ($2,528) is reported as taxable income. Amal should reduce the after-tax dollars in his IRA by that $1,472 (i.e., from $35,000 to $33,528), so that the tax on future IRA distributions can be computed. (If Amal has multiple traditional IRAs, he must find the year-end totals for all of them, make the adjustments described, and pay the indicated tax. It makes no difference which IRA or IRAs the RMD comes from.)
Figuring the correct amount of tax to pay can be complex. That task will be much easier, however, if IRS Form 8606 is filed each year that the IRA contains after-tax dollars. This form, which is filed with federal income tax returns, tracks after-tax dollars in the taxpayer’s IRAs.
The Roth Solution
Other tactics may also reduce the tax on RMDs. For example, converting money in traditional IRAs to Roth IRAs will reduce subsequent RMDs, as Roth IRA owners never have required distributions. The catch here is that Roth IRA conversions are taxable, resulting in tax payments years or even decades ahead of when they’ll be required. Accelerating taxes, though, may be worthwhile if the taxes are paid in a low bracket. If 10% of a traditional IRA is converted each year for 10 years, and all the taxes are paid at a relatively low rate, future taxable RMDs may be minimized or even avoided altogether. Moreover, annual re-characterization of partial Roth conversions may allow more precise fine-tuning for tax efficiency. Such lookback reversals are permitted until October 15 of the year after a Roth IRA conversion.
Suppose Bob and Tina Minoru expect to have around $110,000 in taxable income this year. The 25% tax bracket goes up to $153,100 in 2017, so the Minorus convert $40,000 of Tina’s IRA to a Roth IRA in 2017. When the Minorus prepare their income tax return for 2017, they learn that their actual 2017 taxable income, excluding the Roth IRA conversion, was $123,400. At this point, they can recharacterize just enough of Tina’s Roth IRA conversion to bring the reported amount down to $29,700. This brings their taxable income up to the top of the 25% tax bracket, while the recharacterized dollars go back into Tina’s traditional IRA untaxed. Similar Roth IRA conversions and recharacterizations can be implemented in future years for both spouses, reducing traditional IRA balances and taxable RMDs while building up their Roth IRAs for tax-free distributions.
As of this writing, in late 2017, it appears that proposed tax legislation would abolish the opportunity to recharacterize Roth IRA conversions; thus, such recharacterizations might not be available in 2018 and later years.
In the above example, the Minorus will still be paying tax sooner than necessary. Even though they will remain in the 25% bracket, they will pay $7,425 in tax on the $29,700 Roth IRA conversion. They also may owe state or local income tax, and a $29,700 addition to their adjusted gross income (AGI) might cost them elsewhere on their tax return. Nevertheless, the current Roth conversion may well be worthwhile, considering some alternative scenarios.
Suppose both Bob and Tina are employed, saving regularly in their employers’ 401(k) plans. They both roll the balance over to their IRAs when they retire, and they leave those IRAs untouched, growing tax-deferred. Further suppose that the Minorus’ IRAs will have grown so large that by the time they reach age 70½, their RMDs plus all their other annual income will move them into a higher tax bracket than they had while working. If so, their RMDs will be taxed more heavily than expected.
Other factors also might increase the tax rate on the Minorus’ RMDs. Overall tax rates might be higher by then, or they might have moved to a state with higher rates. Either or both spouses might have earnings that push up taxable income and the resulting tax bill. To reduce such risks, the Minorus should withdraw money from their IRAs in a tax-efficient manner.
Younger IRA owners also may want to revise their plans.
The best time to take money from a traditional IRA may be between the ages of 59½ and 70½ because, after 59½, IRA withdrawals will not trigger a 10% early distributions penalty. During this time, IRA owners can take as little or as much from their IRA as they wish without owing any penalties.
The Roth solution outlined above can be combined with this strategy; at five years after age 59½, all Roth IRA distributions will be tax free. Alternatively, withdrawn funds can be spent after paying tax at a favorable rate. Either way, taking money from a traditional IRA will reduce future RMDs.
Withdrawals before age 59½ may trigger a 10% early withdrawal penalty, but there are many exceptions that allow IRA owners to take withdrawals at a relatively low tax rate, without a penalty, at any age. One common exception for taxpayers in their 40s and 50s relates to higher education expenses. For example, Geoff and Cathy Wilder, both age 50, expect their taxable income in 2017 to be around $55,000. During this year, they spent $20,000 on college bills for their son and took that much from Geoff’s IRA. In 2017, the maximum income for the 15% tax bracket is $75,900 of taxable income on a joint return; therefore, the Wilders will remain in the 15% tax bracket after the withdrawal, on which they would owe only $3,000 in income tax, and which will help to reduce their future RMDs.
At the other end of the age spectrum, IRA owners 70½ or older may be able to reduce the taxable impact of RMDs by taking qualified charitable distributions (QCD). Moreover, QCDs recently became a permanent tax benefit, so younger people can plan to use them advantageously.
IRA owners who have reached 70½ can move up to $100,000 each year from a traditional IRA to a charity or charities. To qualify as a QCD, distributions must go directly from the IRA trustee to an eligible charity. The IRA owner will neither report taxable income from the IRA distribution nor receive a charitable contribution deduction; the tax benefit here is that QCDs count as RMDs but are not reported as taxable income.
For example, suppose Victor has a $15,000 RMD for 2017. He typically donates $10,000 a year to charity, so he decides to make those contributions from his IRA via QCDs instead of writing a check. Now he only has to distribute another $5,000 from his IRA and report no more than that $5,000 as RMD income. If Victor makes $15,000 worth of QCDs, to match his $15,000 RMD, he will not have to withdraw any other funds from his traditional IRA if he doesn’t need the money, and he will not have to report a taxable RMD.
QCDs may seem like much ado about nothing, as the lack of taxation on an RMD is offset by the lack of a charitable tax deduction. For many IRA owners, though, this strategy provides tax advantages:
Seniors who no longer itemize deductions will receive no tax benefit from charitable donations. With a QCD, there is a real tax benefit: the avoidance of taxable income from RMDs.
Other IRA owners have large charitable contributions but modest incomes. Itemized charitable deductions cannot exceed 50% of AGI, and carryforwards are limited to five years. QCDs allow such IRA owners to immediately receive a full tax benefit from their philanthropy, up to $100,000 per year.
By using QCDs, IRA owners can reduce or avoid taxable RMDs, thus holding down their AGI. The reduced AGI may deliver benefits elsewhere on their tax return, such as lower tax on Social Security benefits, greater loss deductions from passive investments such as rental property, deductible itemized medical outlays, and less exposure to the 3.8% surtax on net investment income.
Younger IRA owners also may want to revise their plans. As noted, one reason for converting a traditional IRA to a Roth IRA is to reduce future RMDs; however, it might be more tax efficient to keep money in a traditional IRA and plan to eventually use QCDs to trim RMDs. An IRA owner who is now between 40 and 60 might be accelerating income tax payments by 20 or 30 years with a Roth conversion. If that owner retains a traditional IRA, taxes can be deferred until age 70½, and even then the RMD amount will be a small fraction of the total IRA. Moreover, deferring the income tax for those decades also avoids the potentially harmful impact of an increased AGI.