TLDR;
This video explains how diligent saving can lead to unexpected tax burdens in retirement due to Required Minimum Distributions (RMDs) from traditional IRAs and 401(k)s. It highlights how RMDs, combined with Social Security and portfolio growth, can push retirees into higher tax brackets, increase Medicare premiums, and reduce access to valuable tax credits. The video also offers proactive strategies to mitigate these tax consequences, including Roth conversions, tax diversification, and charitable donations.
- RMDs can cause income and taxes to increase in retirement, even without increased spending.
- Strategies like Roth conversions and charitable donations can help manage and reduce the tax burden.
- Proactive tax planning is essential to protect retirement savings and legacies.
Intro [0:00]
Erin introduces the topic of how diligent saving and investing can lead to unexpected tax problems in retirement due to required minimum distributions (RMDs). She explains that RMDs can cause income to increase, potentially pushing retirees into higher tax brackets and increasing their tax burden. The video aims to show how this happens and provide steps to mitigate these issues.
Set The Stage [0:52]
At age 73, the IRS mandates withdrawals from traditional IRAs and 401(k)s, known as Required Minimum Distributions (RMDs). The amount depends on age and account size on December 31st of the previous year. As you age and your balance grows, the percentage you must withdraw increases. In 2033, the RMD age will increase from 73 to 75 due to Secure 2.0.
The RMD Snowball [1:25]
Many people expect their income to decline in retirement, but RMDs can cause it to increase, along with taxes. Even after starting RMDs, an IRA can continue to grow if investment returns exceed the withdrawal rate. For example, with a $1.5 million IRA earning 8% annually and taking required distributions, the RMD and account balance both increase. By age 80, the IRA balance is higher than when RMDs started, and by age 90, withdrawals can exceed $200,000 annually, all taxed as ordinary income.
RMDs Don’t Happen In A Vacuum [3:03]
RMDs are just one layer of income for retirees. Many have multiple income streams, such as Social Security, pensions, or taxable brokerage accounts. For instance, a retiree named Jim receives $3,000 a month from Social Security, and his wife Diane gets $2,500, totaling $66,000 a year. When Jim starts taking RMDs of $56,600 at age 73, their household income rises to about $120,000 before considering other assets.
Why Retirement Income Keeps Rising [4:15]
Retirement income can continue to increase due to RMDs and annual cost-of-living adjustments to Social Security. By age 80, Jim and Diane's Social Security benefits grow to nearly $76,000 (assuming a 2% annual adjustment), and their RMDs are $94,000, resulting in a household income of nearly $170,000. By age 85, their income can reach $223,000, with Social Security at $84,000 and RMDs at $140,000, all without earning a single dollar from work.
The Problem: When Income Becomes A Burden [5:20]
More income means more taxes, which can be problematic in retirement. Increased income can lead to several issues.
Higher Tax Bracket [5:29]
Retirees may find themselves in a higher tax bracket due to RMDs and Social Security benefits.
Medicare Premiums [5:43]
Medicare premiums can increase due to the Income Related Monthly Adjustment Amount (IRMA).
More Of Your Social Security Becomes Taxable [5:55]
A greater percentage of Social Security benefits can become taxable as income rises.
Lose Access To Credits Or Deductions [6:06]
Access to valuable tax credits or deductions, such as energy-efficient credits, medical expense deductions, or ACA premium subsidies, may be lost.
The Warning [6:29]
Even with consistent saving and wise investing, retirement income could push retirees into unexpected tax brackets. This isn't just a problem for the wealthy; it can affect everyday millionaires due to inflation, compounding, and longer retirements. Proactive planning is essential to avoid this tax trap.
The Solution Set [7:02]
There are steps to reduce your future tax burden without overhauling your retirement plan.
Start With Roth Conversions [7:13]
If you are not yet 73 and don't have to take RMDs, consider Roth conversions during lower-income years. This involves paying taxes now at a lower rate, allowing the money to grow tax-free in a Roth account, which doesn't have RMDs. Converting money from traditional accounts reduces future RMDs.
Make The Most Of The Gap Years [7:48]
Utilize gap years, such as those between retirement and Social Security collection or before RMDs are required, to do tax planning and move money from traditional to Roth accounts. These years often have lower tax brackets, making it an ideal time to reduce future RMDs and move funds into accounts without RMDs.
Diversify Your Tax Buckets [8:14]
Instead of relying solely on tax-deferred accounts, diversify your tax buckets. Include Roth accounts for tax-free withdrawals without RMDs, brokerage accounts for unlimited access to funds and favorable long-term capital gains rates, and traditional IRAs/401(k)s for strategic withdrawals to control taxes in retirement. If heavily weighted towards traditional accounts, shift contributions to Roth 401(k)s to create balance.
The Best — And Worst — Uses For A Traditional IRA [9:04]
Traditional IRAs can shape your legacy in positive and potentially painful ways. The best use is through Qualified Charitable Distributions (QCDs). If you're 70 and a half, you can gift directly from your IRA to a charity, counting the gifted amount towards your RMD, avoiding taxes for both you and the charity, and lowering your adjusted gross income. Inheriting a traditional IRA can be a tax headache, especially for adult children in their 50s or 60s. Withdrawals are often required within 10 years and can stack on top of their salary and other income, potentially pushing them into a high tax bracket, creating a "tax torpedo." Proactive planning can help mitigate these consequences for your heirs.