People reaching 70½ must begin what’s called a required minimum distribution, or RMD, from their IRAs and/or workplace retirement plans.
Like it or not, Uncle Sam wants his money from all the years you’ve been able to let your investment contributions grow tax deferred. After all, there are programs and services that need to be funded with your taxes.
“You cannot keep retirement funds in your account indefinitely,” the IRS warns.
And, you need to take RMDs seriously. If you don’t take any distributions, or you fall short of what’s required, you’ll face a whopping 50 percent penalty on the amount not withdrawn as required. Of course, you aren’t limited to the required distribution. You can withdraw more than the minimum.
I often hear from people who are not happy about having to take RMDs.
“If a person is lucky, the day of reckoning comes at 70½, when suddenly that pot of gold needs to gradually slide over the rainbow back into taxable territory,” one reader wrote recently. “And the hit to your adjusted gross income can be massive. [But] a tax attorney I know had little sympathy. 'That’s a good problem to have,’ he said.”
I understand this person’s annoyance about being forced to withdraw money she doesn’t need. But she said something that struck me as a bit overwrought.
“The silver lining on the tax cloud is that if the stock market crashes, my required minimum distribution will fall, too. And, to make me even more satisfied, I can look forward to the day that I need round-the-clock nursing care and/or expensive medicines. Then, the medical deduction will help shield my distributions.”
Okay, so you don’t want to take the required distribution and pay taxes, but hoping for a catastrophe is taking your frustration too far.
Keep in mind that your investment benefited from tax-deferred growth. Additionally, there’s a higher contribution limit for a workplace retirement account than a Roth IRA. In 2020, the annual contribution limit for employees who participate in 401(k), 403(b), most 457 plans and the federal government’s Thrift Savings Plan will increase by $500, to $19,500. The annual limit for a Roth IRA is only $6,000 and an additional $1,000 if you’re older than 50. There are also income limits that prevent some people from contributing to a Roth IRA.
Because a Roth is funded with after-tax dollars, future withdrawals are tax-free. As a result, a Roth doesn’t require a minimum distribution after turning 70½. Contributions to a 401(k) or similar workplace retirement plan are made pretax, which reduces your taxable income. But you will have to pay income taxes at your then-current tax rate when you begin to make withdrawals.
There is a hybrid Roth 401(k) increasingly being made available in employer plans. The annual contribution limit is the same as a 401(k). You still fund it with after-tax dollars. But the Roth 401(k) is subject to the required minimum distribution at 70½.
The different tax treatment of retirement accounts often has investors wondering what should they do.
“If you were 30 years old today, would you invest in a 401(k) or a Roth?” the reader asked. “Would you take the tax hit right now and save money in taxable investment accounts?”
I asked Maria Bruno, head of U.S. Wealth Planning at Vanguard, to provide insight on the Roth IRA vs. 401(k) debate, which often includes investor irritation about being forced to take minimum distributions. Here’s what she said in answer to the reader’s question.
Bruno: For most, taking full advantage of tax-advantaged accounts for retirement is a good planning move. A key reason to invest in a Roth IRA is that the account grows tax-free. Further, there are benefits to Roth IRAs in terms of not having to take lifetime RMDs. Contributions can be accessed tax- and penalty-free, and withdrawals aren’t included in taxable income, so it would not impact the Social Security taxation thresholds or Medicare B premiums surcharges.
That said, if you’re saving in a taxable account, you want to be mindful of investing in a tax-efficient manner — broad market index funds/Exchange-traded funds (ETF) or municipal bond funds/ETFs fall into that category. For those who face this situation and are pre-RMD age, doing annual partial Roth IRA conversions is one way to create tax diversification, which may be lacking if the money is mostly in traditional tax-deferred retirement accounts. Ideally, the conversions are done at presumably lower tax rates than after age 70.
I had some of my own questions for Bruno.
Q: A lot of folks resent having to take RMDs, but as the tax attorney said, it’s not a bad problem to have, correct?
Bruno: RMDs are a reality of traditional, deferred 401(k)/IRA accounts. With these types of accounts, the taxpayer typically gets a tax deduction on the contribution, the account grows tax-deferred, but the moneys are then taxed when withdrawn. The benefit of years of tax-free compounded growth shouldn’t be undervalued. These accounts are a terrific way to build wealth during one’s working years. Tax diversification is a good thing. For those who have built a lot of wealth in these accounts, they could consider doing a series of partial Roth conversions before RMD to help achieve some of that tax diversification. This is individualized, but my point here is that one should start planning for RMDs well before age 70½.
Q: What can people do to reduce the RMD tax hit?
Bruno: If you are 70½ or older and charitably inclined, you can also consider doing a qualified charitable distribution (QCD) from your IRA. You can distribute up to $100,000 annually to a charity from your IRA and the distribution isn’t included in your income.
Q: There are still good reasons to invest in tax-deferred accounts, right?
Bruno: It’s a good idea to maximize contributions to tax-advantaged accounts. These include traditional/Roth 401(k) and Roth IRA options for retirement, and other accounts such as Health Savings Accounts and 529 College Savings plans. These plans offer tax-deferred and/or tax-free growth features, and often tax benefits on contributions as well.
The decision of traditional vs. Roth is really a tax-timing one. For example, do you expect to be in a lower tax bracket when withdrawals are taken, which generally favors traditional, or do you expect to be in a higher tax bracket (generally favoring Roth)? Many don’t really know with the uncertainties of the tax landscape and retirement, so holding both types of retirement accounts offers tax diversification and flexibility later in retirement.
Q: Can you address under what circumstances it might be better to invest in a 401(k) vs. a Roth?
Bruno: It generally comes down to tax rate expectations — current vs. future tax rate. It doesn’t have to be an all-or-nothing decision. If a plan sponsor offers Roth, one can split deferrals between traditional and Roth (keep in mind that employer matches are made to traditional accounts). For young investors, Roth accounts are generally a wise choice — they’re probably in a relatively lower tax bracket and the tax-free growth with years of compounding can far outweigh the benefit of current-year tax deduction.
How did you decide which tax-advantaged retirement plan was right for you? Send your comments to email@example.com. Please include your name, city and state. In the subject line put “My Retirement Choice.”
Retirement Rants and Raves
I’m interested in your experiences or concerns about retirement or aging. What do you like about retirement? What came as a surprise?
If you haven’t retired yet, what concerns you financially?
You can rant or rave. This space is yours. It’s a chance for you to express what’s on your mind. Send your comments to firstname.lastname@example.org. Please include your name, city and state. In the subject line put “Retirement Rants and Raves.”
Subscribe and stay informed
If you’re viewing this post online, sign up to automatically receive Michelle Singletary’s newsletters right into your email box: “Your Retirement” on Mondays and “Personal Finance” on Thursdays
Read and share Michelle Singletary’s Color of Money Column on Wednesdays and Sundays in The Washington Post. You may also see the column in your local newspaper.