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Why RMDs Don't Matter... For Most People
October 1, 2020
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RMD, or required minimum distribution, is an amount of money that a retiree has to withdraw from a traditional IRA, SEP, or SIMPLE individual retirement account. When a retirement account owner reaches 70.5 or 72 years old, then a certain amount of money will have to be withdrawn every year. So, in essence, the percentage distribution from the qualified required account is made by the government and it will make you withdraw cash when you reach 70.5 or 72 as of the new rule.
Now, why is this so important to know? The reason is that not taking the distribution will put a 50% penalty on the cash amount you should’ve withdrawn. It’s something that many individuals would want to avoid.
In reality, for most people, it doesn’t matter. Why is that, and why is this not important for most people? We’ll explore that below and will also mention when this matters for some categories of people.
Why It Doesn’t
Matter for Most People
A 50% penalty is not a small amount, especially if you’ve accumulated a nice sum of money in your retirement account. You’d think that most people would rush to withdraw the cash and avoid the penalty. Still, in most cases, people don’t care about the penalty and so the RMD doesn’t matter to them.
The main purpose of creating a retirement account is so that people can live off the amount stored on the account after retirement. Therefore, most people who accumulated some good sums of money did it with the sole purpose of living off those funds.
So, if the goal of the retirement money is only meant to help you live off it after you retire, then you are taking distributions to help meet your lifestyle requirements. Let’s imagine a situation now, and say that before you retired, you required about $5,000 monthly. With that in mind, you assess the retirement sources of income you will benefit from after you retire, such as pensions, social security, side businesses, and so on. Doing that results in you discovering an income gap which is about $2,000 every month, for example.
In general, people are going to use the distribution taken from their retirement accounts to fill that gap, and as a result, the RMDs are satisfied. With that in mind, an RMD is not something that you should be afraid of.
We’ve made quite an interesting discovery regarding people who go into retirement and have to start using their accumulated funds. Usually, retirees may go into retirement afraid to spend their cash out of FORO, aka the Fear of Running Out. It’s understandable – after all those years spent saving money into a retirement account, it would be terrible if someone ran out of cash during their retirement.
But through the help of a qualified professional and after an analysis has been made, you may be able to create a way to ensure your money lasts as long as you do. If so, RMDs exist as a way to encourage clients to take a few distributions, to have fun and treat themselves. The client could now take the money and enjoy different aspects of life – money that they would normally not allow themselves to withdraw. We like encouraging people to take the money and enjoy it however they want, treating themselves after working so hard for such a big part of their lives.
If you think about it, is life only about building up the biggest stockpile you were able to, and then just look at it and do nothing with it? The money has been gathered with a purpose – to be used. In our office, we have a saying; “True Success is found in the lives you’ve changed… not in the things you have obtained.”
Why It Does
Matter to Some People
Although to most people an RMD doesn’t matter, there are some people for which it does matter. For example, Social Security could be more taxable for those that don’t need an RMD to enjoy or to meet certain lifestyle goals. When it comes to Social Security, you have to know that this source of retirement income is a very tax-efficient one. As such, the more of the retirement income you’re able to get from your Social Security compared to your qualified distributions, then the lower the federal taxes are going to be. Of course, you can ask us about this if you have any questions.
But it doesn’t only make Social Security more taxable. It can also make you bump into the next tax bracket. If that happens, then the income will become even more taxable, which makes things even worse for you.
On top of that, it may also force distribution on you from an account that you may not wish to make a distribution from, which is again not convenient. In some cases, people may require permission in order to spend some cash after they retire. In other situations, you may need that money to make long-term investments to meet certain goals. So, making unnecessary distributions when you’re trying to meet a goal would only prevent growth.
How to Evaluate Whether RMDs Matter to You and What Can You Do About It?
Are you unsure whether RMDs matter to you or not? There’s no need to worry. Here’s how to make an evaluation and discover if an RMD is important for you and what you can do regarding the situation.
- Find Out the Income Gap
- What you need to do is find out what your income gap is. Is it below the RMD, or is it exceeding it? If it’s the latter, then you don’t have to worry about them. Basically, you will already be making a distribution, so it doesn’t really matter.
- Discover If Additional Taxes will be Caused
- When it comes to RMD, an account owner will be taxed at the income tax rate depending on how much of the RMD is withdrawn. But you need to figure out if there are some additional taxes added by the RMD. In case you’re unsure, we’re here to help you. What we can do is make a plan that will help us decrease the gravity of the situation through various strategies.
- Figure Out If SS Will Become More Taxable
Another thing you should do is try to find out if the SS is going to become more taxable. If you’re not sure, you should reach out to us. If we draft a thorough plan, we’ll be able to combat this thanks to proper strategic planning.
Another possible solution for this may be a Roth conversion. A Roth IRA conversion occurs when money from a Traditional IRA – where income tax-deductible contributions applied but distributions in retirement become taxable – is converted to a Roth IRA. The cool thing is that in the Roth IRA, you can make contributions with the after-tax amount of cash. A Roth conversion would be ideal when the balance for a traditional IRA has dropped when it’s at a much lower tax rate, or when there are no Required Minimum Distributions necessary. With that in mind, you should be aware that Roth conversions are not right for everyone.
In Conclusion
RMDs may matter in some cases, but to most people, they don’t. It’s important to know whether they matter to you and what you can do about them. If you need our help in discovering any potential additional taxes or whether the SS will become taxable, don’t hesitate to contact us. We can help you.
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Let's talk about income sources. Which ones are the most tax efficient and as a bonus a few inefficient tax strategies just to be aware of. For the purpose of today's discussion we are not going to bring wages into play here. We are talking strictly about investment income sources. Income Source #1 ROTH IRA Income is the first and most obvious choice here. The benefit of the ROTH IRA if your not aware, (which is okay if your not - we are all about education here) is that you put your money in after you have already paid taxes but anything in the account grows tax free and can be taken out tax free in retirement. There are some nuances you have to be aware of like you must wait to take your distribution until you have had the account for 5 years you must be 59.5 years old but there are also some nuance early allowances like access to your principle portion at any time. But when it comes down to the general tax fee income it is really hard to beat the benefits of a ROTH IRA . We can discuss future pro and cons at another time. Income Source #2 Dividends Stock Income can be a very tax efficient income source for a lot of people. Now to offer some clarity here we are only talking about dividend income from stocks not held in any type of IRA or other qualified plan. The big advantage here is that "qualified dividends" are taxed at Long Term Capital Gains Rates which if you read our blog-post on that HER E , you would know have some major tax advantages. For Single filers you would pay 0% from $0 to $40,000 of income. You would pay 15% from $40,001 to $441,450 and 20% from $441,451 or more. For married filers you would pay 0% from $0 to $80,000 of income. You would pay 15% from $80,001 to $496,600 and 20% from $496,601 or more. As an example a married couple with $170k in income would be in the 24% tax bracket normally but in the 15% bracket on their dividends that were qualified . That is a pretty hefty amount of income taxed at very low rates. It is important to realize this style of investing does carry market risk and you will want to make sure this fits your overall goals and risk tolerance before diving in. Income Source #3 Real Estate Income can offer some wonderful tax advantages. Investing directly in rental real estate is a great way to leverage your wealth and get tax advantaged income but with prices at record highs this may not be the best time for that. The easiest way to invest in real estate is through publicly traded REIT funds that trade on the stock market. The main disadvantage of these types of holdings is volatility. Publicly traded REITs often have a high correlation to the stock market, which may be the opposite of what you are trying to achieve with this type of investment. Instead, consider looking into non publicly traded REITS. They often have a much lower correlation to the stock market as they are not traded like stocks. They get most of their value from the underlying real estate itself and not stock market share prices. But what about the tax advantaged income? The main advantage to rental real estate income is passthrough depreciation. That depreciation is given back to you as a tax deduction in the form of "Return of investment capital", meaning that portion of your income isn't really taxed right now. So lets say you got $20,000 a year in rental income but had $15,000 in depreciation or "Return of investment capital" that would mean you are only paying taxes on $5,000 of income on a $20,000 income source. How great is that. But there is a downside too. That depreciation lowers your cost basis which can increase your long term capital gains taxes if not planned for as part of your overall financial plan. If you want to talk about if real estate makes sense for you click below to schedule a time to chat. Income Source #4 Life Insurance holds many unique tax advantages. Much like the ROTH IRA you put those dollars in after tax. Like a ROTH it grows tax deferred and the distributions can also be tax free just like a ROTH but that is where the similarities stop. Unlike a ROTH there are no contribution limits or age restrictions or holding requirements. Some types even protect your cash value from loss while others are directly invested in the stock market. From a tax perspective here is what makes this strategy so unique. We already talked about distributions being tax free but did you know when you borrow money from your life insurance as income the income you take could still earn interest??? Since it is being taken out as a loan against the account the money stays invested. If you earn an average return of say 7% but only pay 4-5% in interest you are actually making 2-3% a year on income you already took out of your account. How great is that. That is called positive arbitration. The best part is your income is tax free and when you die your beneficiaries also get the remaining balance tax free as well. Income Source #5 Social Security Income can be one of the most tax efficient sources of income in retirement. If you have ever attended one our classes on Social Security planning you may know some of this already but for those that haven't or need a recap lets dive in. Social security can be anywhere between 0% taxable all the way up to 85% taxable. But the unique thing is that social security is never 100% taxable. So at now point will 100% of your check count towards you adjusted gross income for tax purposes. How cool is that. Now how much if it that is taxed is based on provision income. If you missed last weeks video on that click HERE . But basically the lower we can get your provisional income the less taxes you pay on your Social Security which could end up being a big deal long term. These are some of the most tax efficient income sources and when planned for properly you could very well live your life free of the burden of the tax man . However, there are few sources that are not so tax efficient. Not so efficient income Sources IRA/401k Income - Yes you are reading this correctly because IRA dollars are pretax, they have never been taxed before meaning that it is very likely that 100% of that income source is taxed at your federal tax rate. Really the only way to get around this is to fall into the 0% tax bracket which may be hard for many Americans. But don't loose hope just yet. If you have IRAs/401ks talk to us about how advanced planning may help get you to that 0% or 12% rate even with an IRA/401k. Mutual Funds - One of the reasons mutual funds are so tax inefficient is because of internal turn over ratio and what I call phantom income tax. Basically if you own a mutual fund and it sells some of the holdings within the fund at a profit throughout the year you are liable for the taxes on that gain even though you didn't directly sell anything yourself. Believe it or not this can cause unintended consequences like putting you in a higher tax bracket affecting your Social Security income, IRA income etc. Certain ETF's - Certain ETF's also fall pray to this phantom income tax and may have the same unintended consequences. So can you, or should you utilize any of these top 5 Most Tax Efficient Income Sources? I hope this helps making that decision but if you still need helping figuring things out, click the button below to schedule a time to talk.