The Tax Traps in Delaying IRA Distributions

Congress expanded a tax trap for many owners of traditional IRA and 401(k) accounts when the SECURE Act 2.0 was enacted in December 2022.

The law delayed the starting age for required minimum distributions (RMDs) to age 73, effective January 1, 2023. The starting age will jump to 75 effective January 1, 2033.

If you were taking RMDs before 2023, the changes don’t affect you. Anyone who turned 72 during or before 2022 follows the RMD rules in place at the start of 2022.

Those who turned 72 in 2022 must take their first RMD no later than April 1, 2023, and their second RMD by December 31, 2023, unless they qualify for an exception.

If you turn 72 in 2023, your first RMD will be for 2024 (the year you turn 73) and can be taken as late as April 1, 2025.

For those who turn 73 in 2023 through 2032, the starting age for RMDs is 73, and the first RMD must be taken no later than April 1 of the year following the year they turn 73.

The beginning age for RMDs is 75 for those who turn 74 after December 31, 2032

Another way to look at it is that the beginning age for RMDs is 73 for those born from 1951 through 1959 and is 75 for those born in 1960 or later.

You can delay RMDs, but the question is: Should you delay RMDs just because the law says you can? For a lot of people, the answer is “no.”

The first rule of tax planning is to delay paying taxes for as long as possible. But that’s not always the way to decrease lifetime and family income taxes.

Years ago, before we had Roth IRAs and other tools, I crunched the numbers and found that for some taxpayers, the better strategy is to begin emptying a traditional IRA before they had to and reinvest the after-tax distributions in taxable investment accounts. The strategy is optimum for more taxpayers today.

Of course, not everyone has flexibility about IRA distributions. Some people need to begin distributions before RMD age to pay their retirement living expenses, and others need distributions that exceed the RMD amount.

But many IRA owners have options. They need to take a close look at the alternatives and develop a strategy for taking IRA distributions and spending other assets.

There are several potential dangers to leaving assets in a traditional IRA or 401(k) for as long as allowed.

Distributions from a traditional retirement account are taxed as ordinary income subject to your top income tax rate. The IRA might be earning long term capital gains, qualified dividends and other tax-advantaged income.

But it’s all taxed as ordinary income when distributed. It might be better to take the money out of the account early, pay the taxes and invest the after-tax amount to earn tax-advantaged gains and income.

Another danger is your income tax rate might increase. People generally believe their income tax rate declines once they retire. That was the case when we had a lot of tax brackets.

But since the Tax Reform Act of 1986, we’ve had relatively few tax brackets. Many people stay in the same bracket after retiring.

In addition, tax rates for each of the brackets might increase. The Tax Cut and Jobs Act of 2017 is set to expire after 2025. If Congress doesn’t act, tax rates will jump back to their pre-2018 levels.

Or at some point, Congress might raise taxes to close the budget deficits and pay for the outstanding debt.

The big risks for retirees are the Stealth Taxes, which either directly target retirees or affect retirees more than other taxpayers.

The Stealth Taxes include the inclusion of Social Security benefits in gross income, the Medicare premium surtax (also known as IRMAA), the 3.8% surtax on net investment income and others.

The mechanics of how RMDs are computed increase these risks. The percentage of the IRA to be distributed and taxed to you each year increases annually under the life expectancy tables developed by the IRS.

The amount distributed and taxed to you can increase even when the value of the IRA declines.

Also, delaying distributions is likely to cause the value of the IRA to increase and further increase future RMDs. By bunching the RMDs of a higher-value IRA into fewer years, you could be pushed into a higher tax bracket or have more of the RMD taxed at your highest tax rate than would have happened if the distributions had begun earlier and been spread over more years.

Waiting to take distributions also can create tax problems for your children or other heirs.

Beneficiaries who inherit traditional IRAs and 401(k)s must pay income taxes on the distributions just as the original owner would have. Beneficiaries really inherit only the after-tax value of retirement accounts, and that value depends on the beneficiary’s tax bracket.

Remember that the original SECURE Act eliminated the Stretch IRA. Beneficiaries no longer can spread distributions from an inherited retirement account over their life expectancies.

Instead, most beneficiaries must distribute the entire IRA within 10 years.

The SECURE Act’s distribution rules generally increase the taxes paid on the inherited IRA because the distributions are bunched into fewer years. The SECURE Act also eliminates the long term benefits of an IRA’s tax-deferred compounding.

When the IRA owner delays and minimizes distributions, it is likely that higher taxes will be transferred to beneficiaries.

Don’t let Congress and the IRS determine your IRA distribution strategy. Consider the income taxes both you and your heirs will pay on retirement account distributions. Compare the lifetime taxes that would be paid by you and your family under different scenarios and decide on the optimum strategy.

The first mistake many people, even financial professionals, make is to develop a plan by using rules of thumb, general guidelines, or an intuitive analysis. Some look at the results over only a year or a few years.

What you need to do is run all the numbers and examine the results over a long time. The best analysis covers not only the rest of your life, but also after your beneficiaries inherit. Run the numbers using different scenarios and strategies and compare the results.

There are software programs available to help, and of course you can work with a financial planner.

Here’s an example prepared by economist Lawrence Kotlikoff using his firm’s MaxiFiPlanner software.

A married couple has substantial 401(k) balances (about $3 million each), another $250,000 in taxable investment accounts, an expensive home and annual compensation of about $250,000 each. They’re currently 62.

They plan to retire and claim Social Security benefits at 64. They also plan to roll over their 401(k)s to IRAs and delay withdrawals until they have to take RMDs at age 75.

But under that plan, they’ll have significantly less money to spend each year than they do now. Most of their income will pay for regular living expenses, and they’ll have a relatively small amount to spend on discretionary items.

The analysis (which accounts for income taxes) shows a better strategy would be for each to defer claiming Social Security benefits until age 70 and begin taking distributions from their IRAs when they retire at age 64.

This new strategy increases their lifetime Social Security benefits and total lifetime income by about $400,000. It also reduces lifetime state income taxes and Medicare premium surtaxes.

This analysis reaches the same conclusions as other studies over the years. It often makes sense to begin spending from IRAs and other traditional retirement accounts earlier than required to defer claiming Social Security benefits. It is also a good idea for many people to begin spending from traditional IRAs before being forced to take RMDs.

The benefit of the SECURE Act 2.0 is that, because it delays the RMD beginning age, it presents a longer period for effective planning. Most people will retire sometime in their early to mid-sixties.

If they don’t claim Social Security benefits until 70, they have an extended period during which they will have no earned income and will be in relatively low tax brackets. They essentially can pick their tax brackets by choosing how to take income from the different accounts they own.

You have some control over the income taxes due on retirement plan distributions until you claim Social Security benefits and have to take RMDs.

Use this period to implement long-term tax reduction and retirement cash flow planning.