MAY. 15, 2020
Over the last few months, Congress has enacted two pieces of legislation that changed the rules on Required Minimum Distributions (“RMDs”) from qualified retirement accounts. The SECURE Act, passed in December of 2019, moved the commencement date for RMDs from the year you turn 70 ½ to the year you turn 72. The CARES Act, passed in March 2020 in response to the coronavirus pandemic, essentially eliminated RMDs for the 2020 tax year.
But even with all this RMD “relief,” few people are asking the question: “does it actually make sense to skip taking a distribution from your qualified retirement accounts?”
Lower tax rates give retirees more options
While everyone’s situation is different, for people who don’t have a lot of other income, the answer may be no. Remember, tax rates are very low right now. The Tax Cuts and Jobs Act introduced a large standard deduction for retirees, and the first two brackets for taxable income are just 10% and 12%. If those brackets lead to a lower tax rate than the one you avoided when you deferred money into the account, then taking a distribution might be smart, even if it is not required.
As an example, let’s consider a retired 75-year-old couple who receive $40,000 of Social Security retirement benefits and have no other income. To keep it simple, we’ll assume that they pay taxes on 85% of their Social Security (under provisional income calculations, it could be less, but it won’t be more). This means they are starting with $34,000 of taxable Social Security benefits.
Under the TCJA, they have a standard deduction of $27,400 ($12,400 each, with an additional $1,300 each at age 65). They’ll then pay 10% on their first $19,750 of taxable income, and 12% on their next $60,500 of taxable income. Accordingly, if they took distributions totaling $73,650 from IRAs, they would have $107,650 of total income and pay an effective federal tax rate (including their standard deduction) of just 8.6%.
Is 8.6% a good tax rate? It really depends on the marginal tax rate they avoided when they deferred income into their accounts. In 2017 (the year before the TCJA) a married couple filing a joint return with just $200,000 of taxable income would be at a 28% marginal federal income tax bracket. That means that by deferring money into a qualified retirement plan, that couple would avoid a 28% tax on that income. Trading a 28% or similar rate for an 8.6% rate is a good way to take advantage of tax deferral.
More flexibility for Roth conversions
The delay of RMDs also presents more flexibility to do Roth conversions. This is because RMDs themselves cannot be converted to a Roth. A retiree with a $10,000 RMD due, who also converts $10,000 to a Roth, would create $20,000 of taxable income. If that retiree did not have to take an RMD, however, that would allow her to convert the full $20,000 to a Roth for the same tax bill, or maybe just do a $10,000 conversion instead of taking the RMD. The bottom line is that the elimination or delay of Required Minimum Distributions provides flexibility.
Whether you decide to do a Roth conversion depends on your tax rate now compared the tax rate on distributions in the future. Notice I didn’t say “your tax rate” in the future. That’s because if you leave a traditional IRA your beneficiaries, they will end up paying the income taxes due on that account at their tax rate. If you are able do a Roth conversion at a rate that is lower than your beneficiaries are likely to pay, that can be a good opportunity. This is especially true with the elimination of the life expectancy payout or “stretch” option under the SECURE Act.
Avoiding RMDs isn’t always the best option
So, while many people might be tempted to avoid RMDs whenever they can, this isn’t always the best option. The CARES Act is estimated to cost well over $2 trillion. Our national debt now totals over $24 trillion dollars. If you believe this makes higher tax rates more likely in the future, you may want to take a distribution now, even if you don’t have to. If you don’t need the money, a Roth conversion is another way to leverage current tax rates. Your financial advisor can help you decide what will work best for you and your family.