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Owners of substantial retirement accounts received good news recently from both the IRS and Congress, but the changes won’t solve the problems many of them have.
I’m talking about those who aren’t likely to need most of their IRA or 401(k) balances to fund their retirements. Instead, they have other income and assets to pay retirement expenses and plan to reserve the retirement plans as emergency funds and assets for their heirs to inherit.
Impeding these plans are the required minimum distributions (RMDs) due from such qualified retirement plans. The RMDs mean account owners have to take distributions they don’t want or need. The distributions are fully taxable when they come from traditional IRAs and 401(k)s. The RMDs simply increases income taxes and reduces the balances they planned to leave to heirs.
Congress included a modest remedy in the Setting Every Community Up for Retirement Enhancement (SECURE) Act. For decades RMDs had to begin after the account owner reaches age 70½. In the SECURE act, RMDs are delayed to age 72 for those who turn age 70½ after December 31, 2019. As I said, that’s welcome relief, but it doesn’t delay the RMDs very long.
Another modest change will occur when the IRS finalizes recently proposed regulations on RMDs.
RMDs are calculated using life expectancy as determined using tables issued by the IRS. The tables are in the back of free IRS Publication 590-B. Under the tables, the percentage of the IRA to be distributed increases each year.
For example, at age 70½, 3.65% of the IRA is distributed. At age 78, 4.93% is distributed, and at age 85, 6.76% is distributed. If the IRA has solid investment returns, the dollar amount distributed each year also increases.
The life expectancy tables currently in use were developed using mortality rates in 2002. In August 2018, the President signed an executive order directing the IRS to examine the life expectancy tables and determine if they should be updated.
In early November the IRS issued proposed regulations with new, updated life expectancy tables. The proposed tables recognize that life expectancies have increased since 2002. The tables would reduce RMDs accordingly.
Under the current tables, a 70-year-old taxpayer uses a life expectancy of 27.4 years to calculate the first RMD. Under the proposed tables, a life expectancy of 29.1 years would be used. A 75-year-old surviving spouse would use a life expectancy of 13.4 years to compute the RMD under the existing tables, but a 14.8-year life expectancy would be used under the proposed tables.
These new life expectancies make a small reduction in the percentage of the IRA distributed each year. In the proposed tables at age 70½, 3.44% of the IRA is distributed. At age 78, 4.57% is distributed, and at age 85, 6.25% is distributed.
The new life expectancy tables would apply to more than IRAs. They would apply to all accounts that have RMDs, including employer retirement plans (especially 401(k)s), annuities and more.
The current tables remain in effect. The public has an opportunity to comment on the proposed regulation. The IRS then reviews the comments and makes any changes it deems appropriate.
The IRS expects that the proposed tables will be effective for distribution calendar years that begin on or after January 2, 2021.
The IRS estimates that by age 90 the new tables would cause only about a 1% increase in the IRA balance compared to the current tables.
Instead, IRA owners who have enough income and assets outside their IRAs that they don’t need the RMDs to fund living expenses should consider ways of reducing RMDs in the future.
Keep in mind RMDs do more than give you extra taxable income. The RMDs increase adjusted gross income. That in turn can cause more of your Social Security benefits to be included in gross income and trigger or increase the Medicare premium surtax. Higher adjusted gross income also can cause other tax benefits to be reduced. I refer to all these effects as the Stealth Taxes.
An easy way to reduce RMDs is to distribute your IRA early and pay the income taxes. Invest the after-tax amount in a taxable account, which gives you much more control over when the income and gains are taxed.
This strategy also can provide a better benefit to your heirs. When they inherit an IRA, the distributions are taxed to them the same way they would have been taxed to you. But when they inherit a taxable account, your heirs increase the tax basis of the assets to the current fair market value. The appreciation that occurred while you held the assets in a taxable account avoids capital gains taxes.
Another strategy is to convert all or part of the traditional IRA to a Roth IRA.
There also are more sophisticated strategies. You can distribute the IRA and put the after-tax amount in a charitable remainder trust. Or you can use the after-tax distribution to buy a permanent life insurance policy payable to either your children or to a trust for their benefit.
The SECURE Act and proposed regulations recognize the problem RMDs, but they make only a small dent in the problem. To increase your family’s after-tax wealth, you need to take more significant actions. The earlier you start working to reduce RMDs, the better off you and your family will be.