RMDs:

What are they and how can we eliminate them?

As we approach the end of the year, a topic that continues to come up, even though most people haven’t reached the effective age, is Required Minimum Distributions. It’s an ominous term that you hear spoken in dark alleys and the seedy halls of the Capital, but never fully understand until it’s your turn to answer the call. So, what are these nefarious RMDs?

Since even former Presidents aren’t immune, let’s explore further.

IRAs: The unintended IRS partnership.

Now is a great time for some perspective. Those 401(k)s and IRAs that you’ve been diligently saving into for years aren’t solely yours. Yes, you read that correctly. You own all of those qualified accounts in a joint partnership with Uncle Sam. What’s more is that he has a variable rate lien against those accounts, due when you start to take withdrawals. This comes in the form of taxes. Quick math: If you have $1,000,000 in an IRA and your tax rate is 25%, you only own $750,000 of that account. Uncle Sam owns the other part. If taxes go higher, you own even less. Shocking, right? But wait, it can get even worse. What happens if you don’t need to take withdrawals? Does Uncle Sam leave you alone? Well, that’s where RMDs come into play. Requirements of Mass Destruction.

RMDs: The basics.

When you turn 73 (or 72 if you were born before July 1, 1949), the IRS will tap you on the shoulder and ask for their share of your IRAs. Why? Because they have given you decades of tax deferral and have waited patiently to collect. Now is that time. The amount they ask for is based on the previous year’s closing balance multiplied by a life expectancy factor number pulled from the IRS Uniform Lifetime Table. Simple, right?

What happens if I don’t need the money from the IRA? It doesn’t matter what you want anymore. The IRS wants their share and they’re going to start collecting.

What happens if I don’t take my RMD? Great question! You now have the pleasure of paying a 50% penalty on what you owed in addition to still being required to make the distribution.

Is there a way around this requirement? I’m glad you asked, because there is.

Roth Conversions: The unsung hero.

A Roth conversion is a process whereby you take funds from an traditional IRA and convert them into a Roth IRA.

Drawbacks: you will pay the tax up front, and, depending on the size of the conversion, this could be a fairly sizable increase in your tax bill. For example, if you had $100,000 of earned income (work, social security, pensions, annuities, etc) and did a $200,000 Roth conversion, you would now report $300,000 of ordinary income when you file your taxes.

So, why would someone want to do this? Well, there are three reasons, and they’re all pretty good.

First, you are paying the taxes today, at a known rate of your choosing. Taxes are historically pretty low as of the writing of this article. We’re not sure yet what will happen to the Tax Cuts and Jobs Act rates that are set to expire at the end of next year, but most of us have a strong feeling that taxes will continue to go up in the future, if not in 2026. So, why not pay the tax now, while it is a known variable? If they stay the same, you’re still in an identical tax situation. If they go up, you’re even better off.

Second, you get rid of RMDs completely. Roth IRAs are not subject to the same distribution requirements as IRAs. This means you are removing Uncle Sam from the equation and taking back control of your account distribution. The IRS can no longer force you to take distributions that you might not need or want. That’s a benefit worth exploring in and of itself.

Finally, although this won’t benefit you directly, your beneficiaries are better off because of the conversion. When you pass on an IRA after your death, you are passing on that partnership with the IRS. Even worse, now your beneficiaries have 10 years to liquidate the account in accordance with the inherited IRA guidelines created by the SECURE Act 2.0. This could push them into unwanted higher tax brackets while they are potentially in their peak earning years. And while they still have to liquidate a Roth IRA over a 10-year period like they do an IRA, there are no taxes when they do it. Your loved ones are now praising your foresight while you smile down gratefully on the advisor that helped you arrive at this decision.

Takeaways:

Don’t resign yourself to the idea that you have to take RMDs and there isn’t anything you can do about it. Be proactive. Disinherit the IRS and take back control of your tax and distributions.

Disclaimer: This post is for informational purposes only and should not be considered as financial advice. Please consult with a financial advisor or tax professional for advice specific to your situation.