(Bloomberg) — What the IRS giveth, the IRS taketh away.
At age 70½, the bill comes due on all those tax-deferred savings accounts we’ve been building, and this week the oldest baby boomers will begin to reach that finish line — with many millions more to follow.Those waves of retirees will be required to start pulling money from their IRAs and 401(k)s. Following an Internal Revenue Service formula, these annual withdrawals can push you into a higher tax bracket, so financial planners put a lot of energy into building strategies to minimize the tax bite. To be most effective, you need to plan far in advance of the magic age. So anyone with sizable savings may want to get familiar with how these required minimum distributions (RMD) work — and the options for handling them — well before they have to crack open the nest egg. To get a jump-start on what’s involved, here are some quick rules of the road:
1. While you have the option of tapping tax-deferred retirement savings accounts without penalty starting at age 59½, you are required by law to start taking distributions from your IRA, 401(k) and other kinds of tax-deferred accounts by April 1 of the year after you turn 70½. From then on, you have to take money out before Dec. 31 every year. If you are still working at that age and participating in your employer’s 401(k) plan, you may be able to defer RMDs from that account.
2. The amount you must withdraw is tied to an IRS formula based on life expectancy. Say you just turned 70½ and have one $600,000 IRA. An IRS table (PDF) sets your distribution period at 27.4 years. Your $600,000 divided by 27.4 equals about $22,000. Whether you want it now or not, that’s what you have to take out.
3. The penalties for noncompliance are steep. If you forget to take an RMD, or don’t withdraw the full amount, the IRS wants 50 percent of the amount you didn’t withdraw. You can avoid this by having your IRA custodian calculate your RMD for you and automatically transfer the money to an account with them or your bank, a service many offer.
As you’d imagine, things become trickier once you get into tax strategies. For those to work, you must have sizable amounts saved in both tax-deferred and taxable accounts. If you already have a Roth IRA in place, all the better. By shifting money between these accounts, and paying tax on some at opportune times, you can lessen the ultimate tax damage and add years of retirement income. A few caveats: Everyone’s situation is different, and no one can predict future tax policy. One bit of advice that applies to all: Any financial adviser you use should be a fiduciary, required to act in your best interests.
Fill up the bucket
One of the main ways planners help clients facing big RMDs is strategically converting money from a traditional IRA into a Roth IRA, which is funded with after-tax money. That’s because those required distributions can push you into a higher tax bracket, said Kevin Reardon of Shakespeare Wealth Management in Pewaukee, Wisconsin.
At some point after 59½, when a client can tap tax-deferred accounts without penalty, but before 70½, when they must, Reardon has them convert chunks of a regular IRA into a Roth before they retire. The point is to take advantage of a period when they’re in a low tax bracket. Without income yet from RMDs, a pension or Social Security, there may be a gap between current income and the limit for remaining in the 15 percent tax bracket, for example. The point is to fill that gap with money withdrawn from your traditional IRA, pay tax on it and put it in a Roth.
How much you convert depends on a lot of things, including how much you have in taxable accounts both to live on and to cover the tax, and how close your income is to the next tax bracket. And of course, there are big benefits to having money compound tax-free in an IRA. Planners have to weigh these considerations against the chance of a higher tax bracket when you start taking distributions and other income streams kick in. Reardon’s clients typically delay taking Social Security until age 70. That gets them a much higher monthly benefit than if they’d taken it earlier. It also means Social Security benefits — which are taxed to a degree — don’t add to income while clients are trying to fill their 15 percent “tax bucket.”