What are Required Minimum Distributions (RMDs)?

Okay, so what are RMDs? Simply put, they’re the minimum amount you must withdraw from certain retirement accounts each year, once you reach a certain age.

Who do they affect? Well, if you were born after 1960, you likely won’t have to worry about RMDs until age 75. Born before 1960? Your RMD age might be different, so definitely check the rules. This age has been pushed back a few times over the years, mainly because people are living longer.

Why do RMDs exist? The IRS wants its cut! Remember, you haven’t paid taxes on the money in these accounts yet. It’s been growing tax-deferred for years, and now Uncle Sam wants his share.

When Do RMDs Kick In?

Let’s discuss that age thing more. As we mentioned, if you were born after 1960, you’re generally looking at age 75 for RMDs to start.

But, and this is important, always stay updated! Laws change, and so can the RMD age. Keep an eye on any new legislation that might affect you.

The Myth of Even Distribution

Do I have to take distributions evenly from all accounts?

Here’s a common misunderstanding: You don’t have to take your RMD evenly from all your retirement accounts. That’s a myth!

The required amount is based on the total balance of all your pre-tax accounts (think 401(k)s, 403(b)s, and traditional IRAs). You just need to withdraw the total required amount, but you can choose which accounts to take it from.

Strategic RMD Withdrawals

This is where things get interesting. You can actually strategize your RMD withdrawals. How cool is that?

Here are a few ideas:

• Lower Stock Exposure: If you’re getting older (remember, you’re 75!), you might want to reduce your stock allocation. Take your RMD from the account with more stock exposure.
• Capitalize on Gains: Did one of your accounts have a particular asset or stock that really took off? Consider taking your RMD from that account.

This gives you more control over your assets and potential tax hits.

Why Does the IRS Require RMDs?

Let’s circle back to why the IRS requires RMDs in the first place. It’s all about collecting taxes on those previously tax-deferred retirement savings.

Think about it. You’ve been putting money into your 401(k), 403(b), or traditional IRA for years without paying taxes on it now. The government let it grow tax-deferred. But now, it’s payback time.

At age 75, the RMD rate starts around 4% and increases each year.

The “Ticking Tax Bomb” Scenario

Here’s where the “ticking tax bomb” comes in. If you’re a diligent saver and a high-income professional, you could end up with a substantial amount in pre-tax retirement accounts. This can lead to larger RMDs and potentially push you into higher tax brackets during retirement.

Are you:

• Maxing out your 401(k) and 403(b)?
• Contributing to a 457(b) plan?
• Using a solo 401(k) for 1099 income?
• Utilizing a cash balance plan?

If so, you could be sitting on that ticking tax bomb!

Tax Rate Considerations

Here’s a big question mark: What will tax rates be in the future? No one knows for sure.

The choice between pre-tax and Roth contributions is basically a bet on future tax rates. If tax rates stay the same, it doesn’t matter as much. But if tax rates increase, pre-tax contributions could lead to higher taxes in retirement.

Beyond the Basics: RMD Strategies

RMDs might seem scary, but there are actually strategies to manage them effectively.

• Roth Conversions: Convert pre-tax retirement funds to Roth accounts. You’ll pay taxes now, but future withdrawals (and the growth) will be tax-free.
• Qualified Charitable Distributions (QCDs): Donate your RMD directly to a charity. This allows you to avoid paying income tax on the distribution.

Check out more information on Roth conversions.

The Importance of Planning

It’s super important to think about RMDs, even if you’re still in your accumulation years.

Your current savings strategy might be perfect for right now, but you need to keep an eye on the potential RMD implications down the road.

There’s a “window” for Roth conversions. This is a period, often before RMDs begin when tax rates might be lower.

The Roth Conversion Opportunity

This “window” is key! The ideal time for Roth conversions is when your income and tax rates are relatively low.

The goal is to “fill up” those lower tax brackets with Roth conversions. This can seriously reduce the overall tax you owe from future RMDs.

Visual Walkthrough: Financial Planning Software

To really show you how this works, let’s dive into some financial planning software. We use Wealth Harbor (powered by e-Money).

The following examples are based on hypothetical clients, Joe and Jane Smith. No real client data here, promise!

Meet Joe and Jane Smith

Meet Joe and Jane Smith! They’re both 54 years old.

They each make a good income (around $300,000 – $400,000). They’re diligent about maxing out their 401(k) and 403(b) plans and getting employer matches (4% and 6%). They have a couple hundred thousand dollars each stashed away for retirement.

The Power of Time and Compounding

Now, let’s fast forward to age 75 when RMDs begin for Joe and Jane.

They continue to max out their retirement plans and get employer matches. Their asset allocation shifts from 30% qualified retirement to 72% qualified retirement. Consistent savings plus market growth makes a HUGE impact over time.

The Future Value of Savings

The software shows future values, which can seem significant and a little scary. By age 75, Jane and Joe each have around $3 million in pre-tax assets. That’s a total of about $6 million in pre-tax retirement savings.

For high-income professionals who consistently save, this is realistic.

Present Value Perspective

To put this in perspective, let’s convert the future value of their assets to present value (today’s dollars).

That $7.7 million in total assets at age 75 is equivalent to about $4.5 million today. This makes the numbers more relatable. $4.5 million is still a lot, but it shouldn’t be surprising for diligent savers with high incomes.

RMDs in Action: The Distribution Phase

Now, let’s look at the “Plan Distributions” section of the software.

This shows when RMDs start and how they affect income. RMDs can potentially push retirees into higher tax brackets than they expected.

The RMD Shock: A Case Study

For Jane and Joe, RMDs start at $230,000 per year in the first year. Yikes!

These RMDs increase each year as their account balances grow ($230k, $322k, $414k). By age 100, the RMDs are projected to be $720,000 per year.

Of course, these are just projections. There are a lot of assumptions involved but the example shows the potential for RMDs to become substantial.

Beyond the Basics: Additional Savings Scenarios

Keep in mind that the example only includes 401(k) and 403(b) contributions.

Many high-income professionals may also have:

• 457(b) plans
• Solo 401(k)s
• Cash balance plans

These additional savings vehicles can significantly increase the size of pre-tax retirement accounts and, you guessed it, RMDs.

Rate of Return Context

The financial planning model assumes a rate of return of around 7%.

This is a fair market number, but individual returns may vary depending on your investments. So, remember to consider your investment risk and asset allocation when you are projecting future RMDs.

Tax Implications: A Visual Representation

Let’s check out the “Income Tax Chart” in the software.

This chart shows the impact of RMDs on the client’s tax liability. The chart shows a drop in income during the initial retirement years, followed by an increase as RMDs kick in.

The Tax Rate Rollercoaster

During their working years, Joe and Jane pay a significant amount in taxes.

There’s a sharp drop in their effective income tax rate when they retire. But as RMDs start, their tax rate starts to climb again. So, RMDs can erode the tax benefits of retirement savings.

The Roth Conversion Sweet Spot

Let’s talk about that “golden window” for Roth conversions.

It’s the period between retirement and the start of RMDs. During this time, income and tax rates are usually lower. Roth conversions can help “fill up” those lower tax brackets and reduce the sting of future RMDs. It’s a great opportunity to manage your tax liability.

The Long-Term Tax Savings

Roth conversions might increase your taxes in the short term. But the long-term benefits can be significant.

By paying taxes on a smaller amount now, you can avoid paying taxes on larger RMDs and future investment growth. This can save you a lot of money.

RMDs: A Big Effect on Future Tax Planning

RMDs can significantly impact your future tax planning. You need to be aware of RMDs and manage them proactively through strategies like Roth conversions. Strategies like QCDs or QLAC can help you reduce your tax burden.

Real-World Considerations and Limitations

Keep in mind that financial projections have limitations.

Future tax rates, investment returns, and life can be unpredictable. But the examples give you a good foundation for understanding RMDs and making good decisions. So start planning with the information you have now.

What if Tax Rates Are Lower in the Future?

What if tax rates are lower in the future? If this happens, pre-tax contributions might be a better option. However, Roth contributions still offer tax-free growth and withdrawals, which is valuable no matter what tax rates do.

Beyond Roth Conversions: Additional Strategies

You can also manage RMDs by using Qualified Charitable Distributions (QCDs). Donating RMDs directly to charity can reduce your taxable income.

The Importance of Proactive Planning

Start addressing RMDs now. Don’t wait until you’re forced to take distributions to start planning. If you consider RMDs early in your career, you can make better decisions.

The Advisor’s Perspective: Seeing the Big Picture

Financial advisors use financial planning software to model different scenarios and assess the potential impact of RMDs. They also look at individual client circumstances and goals to develop personalized strategies.

Conclusion

So, are you sitting on a ticking tax bomb? Maybe! But by understanding RMDs and planning ahead, you can defuse that bomb and secure your financial future.