Pre-RMD IRA Planning

Many clients spend decades accumulating income to fund living expenses during retirement. For most, those retirement funds are locked into traditional retirement accounts during the client’s working years. While advisors pay significant attention to making sure clients maximize the value of pre-tax retirement contributions during those working years, it’s also common for clients to start paying less attention to IRA planning options as years go by. That’s often because those funds are “locked up” and, with any luck, in growth mode during working years. Once the client reaches their early 60s, however, it may benefit the client to start exploring their options for their IRA balance. That’s because traditional retirement accounts are “unlocked” once the client reaches age 59 ½--and some clients may actually benefit from taking action sooner rather than waiting until age 73.

Why Are the 60s a Key Time for Planning?

Before the client turns age 59 ½, they’re generally unable to access their traditional retirement funds. Unless the client has experienced a hardship or qualifies for another exception, the 10% early distribution penalty will apply in addition to ordinary income tax rates.

However, once the client reaches age 59 ½, they can access retirement funds without penalty. While ordinary income tax rates will still apply to any distributions of pre-tax contributions, tax rates are relatively low post-tax reform.

So, clients are able to access their retirement funds without penalty but aren’t strictly required to start taking money out until age 73. Once the client turns 73, which is the current required beginning date (RBD) they must start taking annual distributions based on their life expectancy and account balance. If the client takes less than the amount required, they’re hit with a steep penalty equal to 25% of the missed amount (10% if the client takes the missed RMD, files a return and pays the required tax within two years of the original due date for the missed RMD).

Pre-RMD Options for Clients

During their 60s, clients have the maximum amount of flexibility to engage in strategic planning with their IRA and 401(k) funds. They have many different options.

Clients with large account balances may wish to examine their tax situation and start taking money out early. By reducing their account balance in the years before hitting the RBD, the client may be able to reduce the amount of their RMDs during retirement—and reduce their associated post-retirement tax liability. Of course, this strategy really only makes sense for clients who have decided to stop funding their traditional retirement accounts during their 60s.

For other clients it may be time to explore the Roth conversion option. Converting traditional retirement funds to a Roth does generate current tax liability. However, tax rates are at relatively low levels right now (at least through 2025)—and it’s impossible to know whether they’ll be higher in the future, when the client has no choice but to take taxable distributions. The converted amounts must also be tied up in the Roth for five years to give the client the maximum benefits of the Roth account.

However, the client will have created a tax-free income source to draw upon during retirement and, simultaneously, reduced their traditional IRA balance (which, again, will reduce the amount of taxable RMDs during retirement). This diversified approach allows the client to draw from different sources during retirement to both minimize tax liability and make sure their needs are met.

When clients are considering tapping their traditional IRA before reaching age 73, they should also be paying attention to the Medicare income-based surcharges. Taxpayers become subject to the surcharges (known as IRMAA) when their income exceeds certain thresholds. A two-year lookback period applies (i.e., the client’s 2024 Medicare premium rates will be based on their 2022 income).

Conclusion

As with any tax reduction strategy, clients should be aware of both the pros and the cons before taking any action. However, for clients who are interested in reducing future RMDs, the mid-60s may be the prime time to act.

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