Ed Slott is one of the best tax experts in the country.
He has said many times that an “IRA is an IOU to the IRS.”
Simply stated, your large 401k accounts and Personal IRA’s have 3 huge TAX problems for individuals, families, and the next generation as well.
The 3 Tax problems heading your way are the Required Minimum Distribution (RMD), the Widow’s Penalty, and the Inherited IRA.
How to Calculate Your RMD
We first must understand how the RMD is calculated. Most investors don’t think about the RMD until it’s too late. However, if you’re not trying to mitigate the upcoming tax problem to reduce the large 401k and IRA balances with Roth conversions, Qualified Charitable Distributions (QCDs), and other strategies, you could potentially pay unnecessary taxes. If that happens, then you could potentially be bumped into a higher tax bracket which has a negative effect on your Medicare surcharges (IRMAA) and Social Security payments to be extra taxed as well.
Here is a chart on how to calculate your Required Minimum Distribution with a couple of examples.
In example 2 the investor will be required to take out $37,735.85 and pay taxes on that income. If they were only taking out $20,000 to live off, then this is where the problem lies.
To help mitigate this from happening you have 3 strategies. One is to put a plan in place for Roth conversions and reduce the size of your tax deferred accounts. If we do this for 10 to 15 years, we can maximize the 24% tax bracket without going over and prepare for the RMD efficiently.
Another way to look at Roth conversions is if a client is still working, and if they are in the 22% bracket or higher, but potentially fall into the 10 or 12% bracket when they retire. The time between when wage income ends and age 70, which is the longest possible delay of Social Security benefits, could be the perfect window to convert funds in a traditional IRA to a Roth IRA. For higher income clients whose Social Security benefits are likely to be 85% taxable throughout retirement, that window extends to age 73, when the RMDs begin.
The second is using other sources of income when you’re approaching retirement and in full retirement. Here are sources of income thatdon’t impact the Medicare premiums or increase taxable income.
-Health Savings Account (HSAs) withdrawals for qualified medical expenses
-Qualified Roth distributions
-Loans from cash value life insurance policies
-Reverse mortgage proceeds
The third strategy is utilizing Qualified Charitable Distributions or QCDs when you obtain the age of 70.5. Do something good in this world and donate to your favorite charity.
An alternative to a QCD is the donor-advised fund (DAF) which can be a valuable wealth-planning tool that enables clients to give more strategically. For instance…
Minimize capital gains by contributing long-term appreciated securities.
Unlock client illiquid assets such as real estate, private equity and other non-cash assets in support of their charitable-giving and estate-planning goals.
Receive an immediate tax deduction with the option to recommend grants to charities over time.
Build a legacy of giving by involving family members in grant recommendation decisions.
The Widow’s Penalty
The second tax ticking time bomb is the Widow’s Penalty. When my father passed away in May of 2024, it was obviously a very traumatic experience. I couldn’t even imagine what my mom was going through. Over 50 years of marriage with the same spouse and raising 3 children is devastating to lose your husband.
So, we received communication from Medicare that her Part B and Part D premiums will significantly increase from the prior year. Also, I mentioned to my family that she will now be in a much higher tax bracket when filing her most recent tax return.
To explain this in simpler verbiage, the widow’s penalty is when a surviving spouse ends up paying more taxes on less income after the death of their spouse. This doesn’t happen in the same year of the spouse’s death. This happens when a widow or widower starts filing as a single filer the year after their spouse’s death.
Inherited IRA
The third Tax Ticking Time Bomb is the Inherited IRA. Many individuals and families tell me that they plan on giving what’s left over in their nest egg to their children. We have to plan for this event, but it’s a wonderful strategy to help their children.
To frame this another way, they want to use their tax-deferred accounts as legacy assets for their children.
However, the problem occurs because of the new 10-year rule in the SECURE Act.
For this article we will focus on non-spouse beneficiary, the children of a deceased parent and the rules that apply along with how to mitigate the tax ticking time bomb.
An Inherited IRA from a parent to their children has to pay the taxes on the entire portfolio balance within 10 years. Also, if the RMD has already begun while their parent was alive, then the child must continue the RMD, but at the child’s IRS Expectancy Lifetime Tables versus the deceased parent.
If that adult child is in their prime working years, this Inherited IRA could potentially push them into a higher tax bracket therefore less of the gift passed down from their parents because of the tax ticking bomb.
An investor can avoid this with Roth conversions, QCDs, and spreading out your savings into tax deferred, taxable, and tax-free accounts.
A simple summary for anyone reading this article is that tax mitigation planning is the work you do before the tax event, before the distribution, before the conversion, before the RMD, before the death of a spouse that changes everything.
The bottom line is that all of your savings of 40 plus years of hard work needs a superior distribution strategy so that you can pass down to assets to children to avoid taxation.
Key Takeaways:
-Plan for the death of a spouse.
-Strategic Roth conversions over time
-Reduce taxable outcomes with HSAs, QCDs, and Roth conversions to reduce AGI.
-Consider liquidity investments like cash value life insurance for tax payments and IRMAA flexibility.
