Can Delaying IRA Distributions Raise Your Taxes?
This article, published in Forbes, is available to paid subscribers. In five days, it will be available to free subscribers as well.
The answer, as I wrote in today’s Forbes article, is definitely yes!
But let me provide some background for why this question is of particular current relevance. Then I’ll provide some illustrations based on my company’s software, maxifi.com, to point out that definitely yes could, depending on your situation, be definitely no.
This year Congress will likely pass The Secure Act 2.0 (formally, Securing a Strong Retirement Act of 2022), which, like The Secure Act of 2019, enacted under President Trump, will raise the age at which you need to take distributions from regular (taxable) IRAs and from your employer 401(k), 403(b), and similar accounts. The only exception involves retirement accounts of employers with whom you are still working
Before the passage of the Secure Act, RMDs (Required Minimum Distributions) began at age 70 1/2. The Secure Act raised that to age 72. The Secure Act 2.0 (at least the House version) would raise the age to 73 this year, to 74 in 2029, and to 75 in 2033. The Secure Act 2.0, which has other important provisions, looks headed for passage. Democratic and Republican House members of Congress won’t be caught riding an elevator together, but they’ve passed the Secure Act 2.0 by a vote of 415-5. And, although the Senate has its own spin on the bill, its version also includes an increase in the RMD starting age — to 75 by 2032.
Deferring cashing out your IRA has two advantages. First, you can earn income tax-free inside your account. This is called inside build up. Second, you can wait to make IRA withdrawals until your tax bracket is relatively low. Inside build-up isn’t what it used to be given interest rates are so low. As I write, the return on 1-year Treasury bills is a measly 1.7 percent. Worse, there’s no way to safely get even a real (after inflation) return apart from buying things you’d otherwise be buying in the future and simply storing them. If you invest in 1-year T bills, inflation may continue at its current 8.5 percent annual pace. If so, your real (after-inflation) return will be negative 6.8 percent! That’s a nasty hit. But it could be far worse if inflation is lots higher. Yes, you can invest in the market, but on a risk-adjusted basis (and the stock market is currently particularly risky), this is no different from investing in 1-year Treasuries. Or you can invest in 1-year TIPS (Treasury Inflation Protected Securities) and lock in your real loss at the prevailing negative 3.24 percent real yield. But even this supposed safe way to lose money isn’t for sure. If inflation were, for example, 20 percent, you’d have to pay extra taxes on the 20 percent inflation kicker. If you’re in the 30 percent bracket, this would mean an additional 6 percent real loss due to the extra taxes.
It’s one thing to know that by deferring withdrawals you are saving taxes while earning a decent or at least zero real return. It’s another thing to know that to garner the measly deferral advantage you have to invest at significant risk. In short, gambling on an unsure, but almost assuredly bad real return to repay in the future what you can pay for sure now makes little sense.
The other argument for waiting to withdraw — doing so at a lower tax rate — only makes sense if you’ll actually be in a lower tax bracket. That’s not an easy calc especially given the non-linear and non-indexed manner in which Social Security benefits are taxed and Medicare Part B premiums are levied. Clearly, compressing most of your taxable IRA withdrawals late in life might land you in higher brackets than if you start withdrawals early. Moreover, most households are too cash constrained to wait till, say, 75 to start drawing on their taxable retirement accounts.
Given these concerns, why are essentially all members of congress hell-bent on raising the RMD starting age? My guess is they believe it will help them personally. If this seems overly cynical, I wish you had been with me in 2017 when a US senator was asking me to help him make the case for special provisions in the Tax Cut and Jobs Act. I hadn’t met him, originally formed a good impression after a serious of initial meetings and phone calls, but increasingly realized he was focused on amending the pending law in a way that would help his own company. We quickly parted ways never to talk again. But the senator held out to the last minute to ensure he got the tax break he personally wanted based on what I felt were completely bogus arguments. In short, when you see congress bearing tax gifts, it’s likely delivering the gifts to themselves.
As for what you should do, the answer is there is no general answer. Let me illustrate this point using MaxiFi.com. Take a hypothetical, age-60, single retiree named Dan who made close to $115,000 when he retired last year. Dan lives in DC and plans to take Social Security at 70 and start smooth IRA withdrawals at 72. He’s investing in short-term T-bills. Dan’s assuming inflation will quickly moderate, leaving him with an annual negative .5 percent return.
Dan has $3 million in his IRA and $100K in the bank. That’s a terrific nest egg compared to most retirees, but Dan’s plan entails extremely tough sledding for the next decade. His real, post-tax, annual spending budget on everything, including housing, is less than $9K a year. At 70, when Social Security kicks in, it jumps to almost $42K. And from 72 on, it jumps to $97K.
Clearly, waiting till 75 to start withdrawals, whether RMDs or more, would exacerbate Dan’s cash constraint. But would it save him taxes? To check, I ran the program’s robo-optimization that searchers for the Social Security and IRA withdrawal-start-date strategies that jointly maximize users’ lifetime spending. The tool found Dan an extra $221K! That massive amount represents roughly 2.5 years of Dan’s after-tax earnings in the final years of his career.
So, what’s the magic trick? It’s not taking Social Security earlier. Dan’s plan — to take Social Security at 70 — when his retirement benefit starts at its maximum value — is dead on. No, his extra spending capacity is due to reducing taxes, but not entirely. The tax reduction — federal and DC is $136K. The rest, $85K, comes from Dan’s lowering his Medicare Part B premium payments. The Medicare Part B premium is essentially another highly progressive tax Uncle Sam has quietly added to his long list of fiscal programs. As you reduce the number of years during which you take taxable retirement account withdrawals, you raise your modified adjusted gross income in those years. And this can land you in much higher Part B premium brackets.
What if Dan were still working with 65 as his retirement age as well as his Social Security benefit start date. Now Dan’s optimal age for beginning smooth IRA withdrawals is 66, not 60. Indeed, waiting till 66 raises his lifetime spending by $19K. And if Dan works through 65, but waits till 70 to take Social Security, his optimal age for starting IRA withdrawals changes yet again — to age 64 from age 66. These moves produce a $200K increase in lifetime spending coming primarily from higher lifetime Social Security benefits.
In optimizing his lifetime spending, Dan reaps another huge bonus. Whether he retires at 60 and immediately takes withdrawals or retires at 65 and starts withdrawals at 64, Dan’s cash-flow problem essentially disappears. For example, if Dan retires at 65, smoothly withdrawals from his IRA starting at 65, and takes Social Security at 70, he gets to spend $88K annually through age 70 and $89K thereafter.
The bottom line? Don’t be taken in by what Congress suggests is best. Each of us has an optimal retirement account withdrawal strategy that is highly sensitive to our particular circumstances as well as our retirement as well as other decisions. For some households, taking RMDs and only RMDs may be optimal until very late in life. This would likely be the case if, for example, Dan had a very young spouse with little in the way of earnings or assets. For others, like the Dan portrayed here, taking withdrawals quite early — far earlier than any Wall Street firm would advise (I wonder why.) — is, in fact, optimal.
Laurence Kotlikoff is a Boston University Economist, a NY Times Best Selling Author, President of maxifi.com, and Author of Money Magic.
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Isn't this also the argument for making Roth conversions of your tIRA's before your RMD's kick in?