Large retirement account balances can cause tax problems
Putting off distributions and holding assets in your retirement accounts as long as possible may seem like a good idea. However, waiting too long can cause a major tax problem. When you reach age 73, the trigger requiring minimum distributions (RMDs) from qualified retirement accounts begins. This can potentially cause unwanted tax obligations. Here are some tips for tax-effective retirement planning.
Required minimum distribution is a formula applied to traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k), 403(b), and other defined contribution plans that calculates how much you must withdraw from your retirement accounts each year. If you fail to take out the minimum distributions, amounts not distributed on a timely basis can be subject to a 25% penalty (or 10% if the problem is corrected within two years).
Note: Before 2023, the RMD penalty was a whopping 50%!
Thankfully, other beneficial rule changes impact the required minimum distributions:
- There is no requirement to make distributions while you are still working. You may now delay withdrawing funds from employer plans like a 401(k) past age 73 if you are still working and are not a 5%-or-greater company owner.
- RMD rules are different for Roth accounts. Roth IRAs are not subject to the RMD rules while you are still living. And beginning in 2024, Roth 401(k) and Roth 403(b) minimum withdrawals are not required.
The RMD rules ensure the deferred tax benefit for certain retirement accounts does not extend indefinitely into the future. In other words, the IRS wants their cut by applying income taxes to your tax-deferred savings account balances. The amount you must take out each year is based on your age, your spouse’s age, and your filing status.
If you wait to start taking money out of your retirement accounts, the balance in your accounts may be very high when you reach age 73. These higher balances mean a higher annual taxable withdrawal amount. If your required retirement plan distribution is large enough, it may apply a higher marginal tax rate on your withdrawals and trigger taxes on your Social Security benefits. Depending on your income and filing status, up to 85% of your Social Security benefit can be subject to income tax. The key is to be tax-efficient in your withdrawals every year, long before the required minimum distribution rules remove your planning flexibility.
Tax-effective retirement planning
- Plan withdrawals. Once you hit age 59½, you may withdraw money from qualified, tax-deferred retirement accounts without experiencing an early withdrawal penalty. To reduce future tax risk on your Social Security benefits, manage annual disbursements from your retirement account(s) to be more tax efficient when you reach age 73.
- Start receiving Social Security. You may begin receiving full Social Security benefits after reaching the minimum retirement age. But remember, your benefit amount can increase if you delay your start date for receiving Social Security benefits until age 70. Consider this part of your plan to be tax-efficient.
- Contact our RRBB advisors. There are many moving parts to planning for retirement. These include Social Security benefits, pension plans, savings, and retirement accounts. Ask for help to create the proper plan for you and your family. One plan element should include being tax-efficient to avoid the tax torpedo.
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