All through our working years, we are told to save, Save, SAVE for our retirements, so that when the time comes, we have enough money to support us in our “Golden Years,” when we are no longer earning an income. And as an incentive to save for retirement, the government offers us a current tax-break on the income that we contribute to our traditional (i.e., non-Roth) retirement accounts. Put money into your traditional 401(k), 403(b), Deductible IRA, etc., and you do not pay taxes on these dollars in the year the income was earned. If you earned $80,000 in 2022, and put $10,000 into your traditional 401(k) at work, you only pay federal and state taxes on $70,000 in that year. You do not currently pay federal or state taxes on the $10,000 that went into your traditional retirement account. This all sounds wonderful, and in many ways it is, but as with all things in life, there comes a time to pay the piper. And this is where the wacky world of Required Minimum Distributions (RMDs) comes into play.
The idea is: save now, so that you can spend later. Once you turn age 59½, you can start to take money out of your retirement accounts without paying any penalties for premature distributions. And, with traditional retirement accounts, when you start to take money out is when taxes finally become due. In reality, you did not actually avoid paying taxes by contributing to your traditional retirement accounts; you simply deferred paying taxes until a later date. The prevailing wisdom is that this is all still a good deal, as you were likely in a higher tax-bracket when you originally saved the money and received the tax-deduction (while working), and then in a lower tax-bracket when you begin actually taking the distributions and paying the taxes due (while no longer working).
But here is where things get a little confusing. As odd as it may sound, even if you do not need to take money from your traditional retirement accounts, the IRS still wants to get their tax dollars at some point. So, once you turn a certain age, you are forced to start taking distributions from these traditional retirement accounts. These forced distributions are called Required Minimum Distributions (RMDs). There have been changes over the years about when you have to start taking annual RMDs, with the most recent change being made as part of the SECURE 2.0 Act that was signed into law in December of 2022. Currently, if you have not already started, you must start to take RMDs from your traditional retirement accounts in the year you turn age 73. Starting in 2033, this changes to the year a person turns age 75. Unless, of course, they change the rules again in the next ten years, which, based on past precedent, seems more likely than not.
So, How Are Required Minimum Distributions Calculated?
RMDs are based on only two factors: the balance of your traditional retirement accounts as of December 31st of the prior year; and your IRS-determined life expectancy. The RMD calculation is really quite simple: you take your traditional retirement-account balance as of 12/31 and divide this amount by your IRS-determined life expectancy. In case you are curious, here is a link to the current IRS life expectancy table: IRS Life Expectancy Table. As you can see, if you are age 75, the IRS gives you a life expectancy of 24.6 years. So, if you are 75 years old (or will turn 75 this calendar year), and had a traditional retirement account that was worth $100,000 as of 12/31 of last year, the equation is as follows:
$100,000 / 24.6 years = $4,065.04.
As such, in this scenario, you would have to take out, and pay taxes on, $4,065.04 this year. And then, next year you do the equation again, and on, and on, and on, until the account balance is at zero, or your life balance is at zero, whichever comes first.
Some people find themselves in the enviable financial position of not needing to take money from their traditional retirement accounts to maintain their retirement income needs. I often get told by clients, “I don’t need this money right now”, and asked, “what can I do?” In this fortunate scenario, there are two basic options to consider.
First, just because you have to take money out of your traditional retirement accounts does not mean you have to spend it. Yes, you have to pay taxes on the distribution, but there is nothing stopping you from putting it right back into a non-retirement bank account or an investment account for further growth potential.
A second option is, if you are planning to give money to a qualified charity or charities in the coming year, you can use some or all of your RMD to do so, and thus likely avoid paying taxes on these dollars altogether. This is called a “Qualified Charitable Distribution.” Now, it is important to understand that it is not worth giving to charity just to avoid paying taxes on your RMD. That is like paying $1.00 to get back $0.40 (or something like that, depending on your overall tax-bracket). However, if you are over 70½, and are already planning to give to charity, doing so via a Qualified Charitable Distribution may well be the most tax-efficient way to accomplish your charitable goals.
Anyone over age 70½ can give up to $100,000 per year to qualified charities from their traditional IRAs and not have to pay taxes on these dollars. And, with changes to the tax laws in recent years, it has become harder to qualify for a full deduction on your taxes when giving to charity directly from non-retirement accounts. As such, Qualified Charitable Distributions have become the most tax-efficient way for many people over age 70 ½ to give to charities (up to $100,000/year). It is important to know that the charity must receive these funds directly from your IRA and they must be received before December 31st. You cannot take the money out of your traditional retirement account, park it in your regular bank account, and then send it to a charity. This nullifies the tax-benefits of the strategy completely, as it is not considered a Qualified Charitable Distribution. You will need to work with your advisor or custodian to have the money sent directly from your traditional IRA to your charity of choice; then, you will have to work with your tax-advisor to make sure the distribution is coded and taxed correctly on your tax-return. So before you run out and start giving money to charity from your traditional IRAs, please consult with your tax advisor. Everyone’s situation is different and all tax matters should be discussed and confirmed with your tax advisor before making any final decisions, in order to make sure it is really the best strategy for you and what you are trying to achieve.
A final thought here…
I get many people who tell me that they feel they are being unfairly “penalized” for taking money out of their traditional retirement accounts. For instance, they may want to take the kids and grandkids on a Disney cruise that will cost $20,000. After talking with their CPA, we determine that they actually have to take closer to $30,000 out of their traditional IRA, have $10,000 withheld for taxes, and then get the $20,000 they originally desired. They are so outraged by this IRS tax “penalty” that they forgo the trip altogether. But here is the thing: paying taxes is not a penalty. You got a tax break in the beginning – tax deferral for all of the years thereafter – and now, the tax bill has simply come due. As I said before, you will always have to pay the piper eventually. But don’t let that fact get in the way of your enjoying the money you have spent a lifetime earning, and saving. Taxes are not a penalty. They simply mean you have made money, and yes, the government eventually wants its share.
We are not tax-experts and are not offering tax-advice here. Please discuss all tax matters with your tax-consultant and/or attorney before making any decisions.
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