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By Dr. Jim Dahle, WCI Founder
I have written before about Required Minimum Distributions (RMDs) and how many investors freak out unnecessarily about them. RMDs used to start at age 70 1/2, but under current law, most of us not already taking them won’t have to before age 75. Basically, starting at age 75, an investor has to remove a certain percentage of tax-deferred accounts (about 4% at age 75, but increasing to more than 10% in your 90s) from the account each year and pay taxes on it. Roth, or tax-free accounts, do not require RMDs to be taken.
Some people, typically those with a lot of other income in retirement from pensions or those who have fully depreciated rental properties and those who are super savers, actually do have what I call “an RMD problem.” I define an RMD problem as someone who takes out their RMDs and pays taxes at a higher rate than they saved when they made the initial contribution. If you contributed at 22% and later pulled the money out at 35%, you have an RMD problem. You should have made Roth contributions and/or done Roth conversions at any rate up to 35% (or even slightly higher) in prior years.
Life is unpredictable, and sometimes you don’t know what your future tax rate will be. Plus, there were many years when Roth 401(k) contributions were not available to many savers. So, it happens. It can be complicated, too, because it’s not just about the tax brackets. It’s also about the gradual phaseouts of some deductions and the occasional “cliffs,” such as those associated with IRMAA.
The Other RMD Problem
However, there are some investors who have another RMD problem. Or at least they think it’s a problem. The really short-sighted folks just don’t like paying taxes and they’re mad about it. They just wish they didn’t have to take RMDs at all. Occasionally, one of them does something stupid to avoid this “problem” which usually results in paying more taxes. This includes:
- Not making retirement contributions in the first place
- Making a Roth contribution during a peak earnings year when a tax-deferred contribution would have been smarter
- Taking money out of a tax-deferred account before retirement age and investing it in taxable
- Doing Roth conversions at a very high tax rate
These people just need to remember that the goal is to have the most money after-tax, NOT to pay the least amount in tax (much less pay the least amount possible in taxes on RMDs). If you want to pay the least amount in tax, live like that under the aqueduct in a cardboard box. No taxes; not so appealing now. Same thing with lots of the “zero tax” strategies being promoted by misguided advisors and gurus.
Once people get beyond just being mad about paying taxes, lots of them think they have an RMD problem when they don’t. The problem they think they’re having—the “other RMD problem”—is that they are having to take RMDs they don’t actually want. They don’t even want the income to spend. That’s not an RMD problem; that’s a rich person problem. You have more income than you need. You might even be a net saver during what are usually the decumulation years. You’re “at risk “of having this “problem” if you find you are getting close to RMD age and have not even thought about touching your retirement accounts.
If you have to take out RMDs that you don’t need to spend, you simply take the money out of the tax-deferred account, pay the taxes on it, and reinvest it in your taxable account. A surprising number of retirees do this. It’s hard to switch from being a saver to being a spender. It’s also hard to get exactly the right amount of retirement assets for your income needs, so some people just end up oversaving. Plus, most retirees spend less as they go through retirement (at least until the last couple of years when medical expenses skyrocket). By the time you get to RMD age, you’re already past the “go-go years” and rapidly approaching the “no-go years.”
However, you shouldn’t beat yourself up about this. The way to think about this is that you’ve maxed out the benefits of your tax-deferred accounts and now have to invest in taxable, not that you’ve somehow done something wrong.
If you live for a long time after age 75, that loss of tax-protected growth can be significant. It could even be enough to cause your overall tax burden to increase, even if you saved the money at a 35% tax rate and took it out at a 25% tax rate. But given the average life expectancy of a 75-year-old, that’s probably not an issue. Plus, heirs benefit from that step up in basis on the now taxable assets.
However, if you have this RMD problem, which is the “other RMD problem,” let me give you a few suggestions.
Ways to Deal with the Other RMD Problem (i.e. Being Too Rich)
There are lots of strategies you can employ. Let’s go through them.
#1 Spend More Money
Congratulations! Well done! You did a great job saving for retirement. You did such a great job that you have more than you need. You ought to at least give some consideration to actually spending that RMD money. Fly first class or your heirs will. Hey, why not take those heirs on a Caribbean cruise? You’re only going to be driving for a few more years, so why not get a really nice luxury car? Stay in five-star hotels instead of three-star hotels. Pay for some help to come in and do whatever needs doing. Renovate your bathroom. Get custom-fitted golf clubs. Get a bigger boat. Go heli-skiing. Go to Michelin three-star restaurants. Do whatever. An entirely reasonable retirement spending strategy for those with all or most of their money in tax-deferred accounts is to simply spend the RMD. Go ahead and do that.
More information here:
A Framework for Thinking About Retirement Income
Fear of the Decumulation Stage in Retirement
#2 Give Money Away
Some people truly can’t think of anything they could spend more money on that would make them any happier. Great! But I bet that’s not the case for all of your friends, family, and future heirs. You can give away up to $18,000 [2024] to anybody you want every year with no hassle whatsoever. So can your spouse. If you give more than that, you have to fill out a gift tax return and the amount over $18,000 is subtracted from your estate tax exemption amount. You probably still won’t owe estate/gift taxes, but the return can be a pain.
#3 Support a Charity
Want to give money AND reduce your tax bill? You can do so if you give to a registered charity. You can take your RMD, pay your taxes, donate the money to charity, and take a charitable deduction for it when you itemize on Schedule A. Tax-deferred accounts are also a great asset to leave to charity. Neither you nor the charity will pay any taxes on that money.
More information here:
Charity — How to Give, Why to Give, and the Tax Benefits You Can Receive
#4 Use Qualified Charitable Distributions
The very best way to give to charity once you get close to RMD age (you can actually start doing this at age 70 1/2 under current law) is to use Qualified Charitable Distributions (QCDs). With a QCD, up to $100,000 per year can go directly from your tax-deferred account to the charity and count toward your RMD for the year. You’re getting the same tax break as you would get with that charitable deduction, but you don’t have to itemize and you’ll get a lower or non-existent taxable RMD. You also don’t raise your Adjusted Gross Income (AGI), which can help avoid some deduction phaseouts and the IRMAA cliffs.
#5 Use Qualified Longevity Annuity Contracts
Another option to reduce RMDs is to purchase a special type of Deferred Income Annuity (DIA) called a Qualified Longevity Annuity Contract (QLAC) using the tax-qualified money in your tax-deferred account. With a DIA, you are trading a lump sum now for a future guaranteed income stream that will not start for a number of years. Essentially, it functions as longevity insurance. Just in case you live to 105, you know you won’t completely run out of money. You can use up to $200,000 of your IRA money (and $200,000 of your spouse’s IRA money) buying QLACs. The amount of money in a QLAC is not used when the calculation of your annual RMD is done.
The problem with this strategy is that if you have so much money that you don’t need your RMDs, you probably don’t need longevity insurance. And insurance, on average, is a bad deal. You’ll probably end up leaving your heirs less than you otherwise would using more traditional investments.
More information here:
I’m Retiring in My Mid-40s; Here’s How I’ll Start Drawing Down My Accounts
#6 Do Roth Conversions
The classic time period to do Roth conversions is between your retirement date and when you start taking Social Security, usually age 70. However, you can do a Roth conversion at any time. Just like money put in a QLAC, money put in a Roth IRA is no longer used to calculate RMDs. If you had a $2 million IRA and converted $500,000 of it one year, your RMD the next year would be calculated on an amount of only $1.5 million.
You have to be careful with this strategy. It doesn’t make sense to pay 37% to do Roth conversions to eliminate RMDs when you could withdraw that money at some lower tax rate. But the wealthier you are and the larger your tax-deferred accounts, the more likely Roth conversions done later in life are still going to be beneficial.
This “other RMD problem” is the ultimate in “rich people problems.” You may or may not want to do anything about it. But if you do, these are your options.
What do you think? Do you have the other RMD problem? What are you doing about it? Comment below!
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