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 the beginning age for RMDs is 73 for those born from 1951 through 1959 and is 75 for those born in 1960 or later.
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.
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 once was the case but no longer is for many retirees. Many people stay in the same bracket or even rise to the next bracket after retiring.
In addition, 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 Congress might raise taxes to close the budget deficits and pay for the outstanding debt.
But 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. Once RMDs begin, the percentage of the IRA to be distributed and taxed to you each year increases each year 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 pay higher income taxes over your lifetime.
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 enacted in 2019 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’s 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.
You need to do is run all the numbers from different scenarios 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.
There are software programs available to help, and of course you can work with a financial planner.
Many studies and projections by me and other analysts reached the same conclusion over the years. It often makes sense to begin spending from IRAs and other traditional retirement accounts earlier than required in order to defer claiming Social Security benefits. It’s 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.