In a previous post, I mentioned retiree tax planning.
In thinking through on this topic, I find that there are additional things to consider.
For funds in a Traditional IRA, the tax advantages when contributing are now due when withdrawing from the IRA. Our withdrawals from a Traditional IRA are added to income for which tax is paid.
The result of participating in the Traditional IRA scheme is that we forego taxes on the contributed amount, but incur taxes on the future withdrawal. Since we can assume that the invested monies will grow, sometime substantially, over time we are incurring a larger and larger tax burden.
While we might want to minimize our taxes due, there is really not much that can be done at that point. We withdraw money, taxes are due. End of story.
Or Not
And as part of the puzzle, we know that any funds converted from Traditional IRA to Roth IRA also requires taxes to be paid.
As a retiree, I initially considered that the best course of action would be to take RMDs as required, and if and when Traditional IRA funds get depleted, eventually withdraw from Roth accounts. I find this view now shortsighted.
I now know that I need to withdraw the minimum amount, the RMD, from taxable account[s]. In addition, I will convert some additional funds from Traditional IRA to Roth IRA as long as I remain in the same tax bracket. The purpose of converting funds to Roth IRA is that I will be minimizing my future tax burden by paying taxes now.
I am making the assumption that paying taxes now is better than paying more taxes later… more because I assume my IRA assets will grow as time goes by. As my Traditional IRA grows, so does my future tax liability. If I have a chance to reduce my Traditional IRA balance, then my future tax burden declines. If I take the tax hit now, I am reducing some of my future tax burden.
There’s More
There is an additional reason to conder this approach. The RMD amount is dependent on a percentage of tax-deferred assets. This percentage is predetermined by the IRS. You can see the “IRA Required Minimum Distribution Worksheet” used to determine the percentage here.
Let’s look at an example. Suppose you have $100,000.00 in tax-deferrred accounts as of December 31 and you are 73 years old. Using the worksheet you see that the “distribution period” is 24.7. Calculate your RMD by dividing $100,000.00 by 24.7. Thus your RMD is $4,048.58. So you take a distribution of $4,048.58. This means your balance in the account is now $95,951.42.
For argument’s sake, let’s say your account increases in value during the year such that it is now again at the $100,000.00 amount. When you get ready to take the distribution for the tax-deferred account based on the balance on the following December 31, you are a year older, now 74, and you find that the “distribution period” is now 23.8. Calculate your RMD by dividing $100,000.00 by 23.8. Thus your RMD is now $4,201.68. Your RMD went up by $153.10 , which also means the tax burden on your RMD went up, even if your account balance remained the same.
Of course, if you have more than $100,000.00 in your account, the RMDs and associated taxes increases proportionally. As a result, reducing the balance in the tax-deferred account, and therefore the RMD, and therefore the tax burden, can be significant.
Dates
After the first RMD year, the deadline for withdrawing RMDs is always December 31. This leaves scant time for understanding one’s tax burden, as income reporting and tax filing occurs after December 31, generally by April 15 of the following year. So I will need to make assumptions and estimates when converting funds from a Traditional IRA to a Roth IRA.
Regardless of the tight timeline, I believe that prospect of paying taxes now rather than later is sound. It seems to be the inverse of investing: Less Now, More Later.
What if your retiree tax plan? Let me know here.
The 1903 Wright Flyer is shown as displayed at the Smithsonian Institution in Washington, D.C. This airplane, is sometimes also referred to as the Kitty Hawk Flyer, Orville Wright’s successful flight was on December 17, 1903.
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