While retirement is a time to relax a lot more, where you sit back and collect, retirees need to be aware of the pitfalls out there when it comes to managing their tax obligations.
You’ve worked hard to build a good-sized nest egg for your retirement, including a nice sized IRA to take you through the final decades of your life, Social Security payments to bolster it, and Medicare benefits to help you keep more of your money at an age where your medical costs tend to skyrocket.
Retirees don’t usually think that much about managing their tax burden at this time of life, a time where people generally get put into a lower tax bracket after they stop working and start collecting benefits like Medicare and Social Security to put more money in their pocket to be in a position to enjoy their retirement years more.
While many retirees who are set up fairly comfortably get professional advice on how to best manage their finances in retirement, a lot of them learn the hard way that this is no time to retire from worrying about your finances or your taxes, but only after they get stung with higher tax bills than they expected or higher Medicare premiums. It’s always better to be aware of where the ice is on your path and look to avoid taking nasty spills if you can, or at least not be surprised by them.
Required minimum distributions (RMDs) with IRAs is a topic that retirees who hold a good amount of money in them are pretty aware of already, because it’s hard to be too unaware of a rule that very transparently forces you to cash in a certain amount of your investments. Many may not think these distributions are all that fair, as it is their money, but that’s not actually the case, as a good part of their IRA accounts contains money that actually belongs to the IRS, who have been letting them hold it for a while but do want it back.
We need to remember that while principal amounts in non-retirement accounts are ours since the IRS has already taken their cut, the IRS does have a stake in the amounts that we have in retirement accounts, since they have deferred the tax that we owe on this money.
While RMDs may be somewhat controversial, with many a complaint from retirees surfacing, we can definitely make sense of why they are required, even though this still may be overbearing and may actually run counter to the interests of retirees.
The underlying principle of them is their seeking to confine these tax benefits to the retirees themselves, not use this as a tool to reduce the tax burden on their descendants. There are other ways to easily manage this though, and the best and most sensible one is to simply close the tax loopholes in estate planning that would remove any advantages to bequeathing tax deferred money, where the tax deferral simply comes off when both spouses die and then is completely treated like normal income.
Instead, RMDs seek to force people to take out required minimums out of their plan, where they have to essentially pay back amounts that they owe in tax on an installment plan like you would get if you took out a loan or mortgage.
That doesn’t seem too unreasonable, but we need to realize that a retirement savings account is not just set up to sustain retirees, but also to help them manage the large and unplanned expenses that we all face, and that older people especially are prone to. This not only may involve big expenses on themselves, but also those of love ones that they may need to dip into their savings to bail out.
Required minimum distributions are targeted to have people spend down their retirement accounts by the time they approach 100, and given that few people live that long, that appears quite reasonable until we consider that there are times where people need to take out a lot more than their minimum in a given year.
While it is true that in theory at least, forcing someone to withdraw from their IRA and forcing them to spend that money are completely separate, and the most this does is have you paying taxes that you actually owe sooner rather than later, but in practice, withdrawing of any sort and spending go hand in hand. People will spend more if they have to take it out of their IRA and this can serve to have them spending their retirement money in a highly discretionary way faster than it may be wise and leave less for the big stuff when it comes.
This is the part that the IRS could benefit from at least rethinking, realizing that the purpose of this money is not just to provide income to retirees, but to also provide a level of comfort to manage big expenses that are not planned or accounted for by this. This is especially important given the risk of high medical bills scuttling carefully laid out plans to provide for ourselves in our final decades.
We’re stuck with this idea of proportioning these savings to get us to 98 though, and we are also stuck with paying tax on these distributions, like it or not. There isn’t even any sense complaining that these RMDs sometimes end up being taxed at a higher marginal tax rate when some of it falls into the next tax bracket up, and what we need to do instead of complaining is to seek to make the best of this and not spend money we don’t need to and at least not fall into that trap.
It’s Never Just All About How Much Tax You Pay Though
Retirees actually focus too much on taxation actually, and this serves to distract them from their overall goal, which isn’t to pay as little tax as possible but instead to have as much money in our pockets as possible after the tax man takes his cut. Tax free municipal bonds for instance look like manna from heaven, and their attachment to the tax-free part blinds them to their being left with even less in the end.
Older folks also tend to be far too conservative with their investments than they should, usually from getting advice from advisors who are far more conservative than they should be, in an industry that is as well. If you are left with less after taxes than you like, you could always just shoot to make more money and leave yourself with more in your pocket after the tax man that way. Retirees need to take this idea to heart but few do, instead choosing to remain with the crusty and derelict investment strategies that have been failing them for years.
The IRS has at least thrown retirees a bone, as somehow, the COVID-19 pandemic has softened them up enough to waive the RMD requirement for 2020. Never mind that there is no logical connection between the two, as the many who hate RMDs aren’t complaining. You can count on this returning in 2021 though, although this is an extremely easy matter to manage, you just take the distributions you need to, pay the tax, and that’s all there is to it.
If people are upset with the “extra” tax that they have to pay on withdrawing by way of RMDs, they can at least console themselves with the fact that this still may represent a tax savings over what they would have paid if they did not shelter this money, and they also can claim the benefit of investing the IRS’ money and getting returns on it for the years it’s been in the plan.
The two things that they say we can always count on is death and taxes, and while older people tend to accept their mortality pretty well, they could probably do a better job accepting the inevitability of taxes, and neither they nor their IRAs will escape these inevitabilities. While we don’t want to turn the other cheek and let them tax that one too, we should not be slapping the cheek they did tax and just add to its sting.
RMDs in themselves aren’t really that big of an issue, but there are some actual pitfalls that many retirees may not be aware of, such as seeing higher amounts of their Social Security benefits become taxed as their income rises, as well as seeing their monthly Medicare premium rise.
This is the another potential dark side of RMDs, where as they increase your taxable income, this not only may have you paying more tax on your IRA money, it also can jack the tax you pay on your Social Security benefits and increase your Medicare premiums, both of which are indexed to taxable income.
It makes sense to give people of lower income a tax break and a lesser one to those who are better off, although with Social Security, everyone does get a little tax break on this income, of at least 15%. This means that you only have to declare 85% of your benefits as taxable, which gets reduced depending on what you make.
We don’t want to be treating those who are just getting by on their Social Security benefits the same way as we do with people making six figure incomes in retirement, just like we don’t tax lower income people the same way as we do higher income folks. It can seem like a real slap in the face though when the IRS first forces you to cash in, and then uses this against you to have you paying more tax on your Social Security benefits as well, taking two slaps instead of one, but this is also part of the reality of our federal tax code.
The same thing will happen anytime our income goes up, including such things as just getting better yields on our investments. People being so infatuated with interest income in retirement over capital gains not only has them choosing inferior investments as far as returns go, they also are inferior as far as tax goes, given they may pay the full tax rate instead of the reduced rates of capital gains treatment.
The Extra Damage that RMDs Cause Is Painful but Unavoidable
Paying more tax, even more tax on Social Security, is at least easier for retirees to swallow if it is because they made more than having this happen through RMDs, because they are at least thinking that they have the additional wealth to offset this and then some. However, in this case, it is what it is, and we cannot treat RMDs as a hypothetical, as if there were an alternative, because the amount of tax you pay in your dreams just doesn’t persuade the IRS.
We may not be able to just grin and bear this, but it wouldn’t hurt to grin, and we do have to bear it regardless. The best that people come up with this is suggesting we donate this extra money to charity, and while such a thing would have the double benefit of ridding ourselves of both the additional tax on the RMD and Social Security if it causes that to happen, we’re giving away a lot more than we save and this plan requires that we value the donation in itself at least almost as much as we would without the additional tax considerations, this extra tax on Social Security income that is sought to be sidestepped.
Seeing your Medicare premium go up as a result of RMDs is something that is even more difficult to swallow, due to the transparency of this. If you have to cough up hundreds more a month for this, out of your bank account, this tends to have a louder bang dollar for dollar than your annual tax bill, mostly because you have to reach into your pocket every month to pay the higher premiums.
This might look like a domino effect from these RMDs, where we may feel that we are being first tied up with them and then have additional punishment inflicted upon us by way of these other two money grabs, but being disenchanted in itself isn’t going to change anything but make our experience with all this worse. Unless you can get the IRS to change their minds here, and good luck doing that, you are just hurting yourself more by being upset with these things.
This does not mean that we may not see some positive reform one day, and the solution would be to treat RMDs as a tax obligation but not as qualified income for these other programs. This would just fall upon deaf ears right now though and this is just one of the things about taxation that a lot of people aren’t that fussy about but you can’t fight the tax man.
Fair or not, we have to pay attention to this stuff, at the present time anyway, and who knows that the future may hold. The good news is that, aside from no RMDs in 2020, the age where these redemptions must be made has increased from 70 ½ to 72. The half year was always wonky anyway although if this meant an extra 6 months of a reprieve from this, and that’s a good thing. An extra 1 ½ years on top of this is even nicer.
This does put it further out from our working years though, the time we’re told that we should be considering these things. It’s not even that you can decide when you are in your 65th year if that’s when you’re retiring, as changing course to divert money away from IRAs the right way takes longer than this. You can collapse it all in one year, but this would involve a huge tax bill and considerably more than doing this more gradually.
This does bring some different calculations than people usually make, even though people generally don’t do much calculating anyway when it comes to these decisions. Depending on the effects to Social Security tax rates and Medicare premiums, this might even make it worthwhile to pay a little more tax and take out more at once, not the goal of less, when this means that you will need to take less in future years and you save more from this than it costs you to do the bigger withdrawal.
This also makes the Roth plan look better, where you don’t get the benefits of investing the government’s money for years, the tax you deferred, but you don’t ever pay tax or declare withdrawals as income.
Someone may read this and wish that they had their money in a Roth IRA instead, but they may not wish to unload the entire amount on their taxable income at once, although at least some degree of this may make sense, especially amounts that don’t require higher marginal tax rates.
Situations differ considerably, so this requires close individual assessment, but a little time spent on this can pay real dividends. We need to keep well on top of any changes to these things though. Knowledge is power, especially with taxation.