Many people have a time bomb waiting to go off. Are you one of them? What is the time bomb? The time bomb is large tax deferred accounts like a 401(k), 403(b), 457, TSP or Traditional IRA. If those accounts add up to over $500,000 or more, you might have yourself a time bomb that will be going off in the near future. Will this apply to you and what can you do about it? Let's see.
The time bomb can go off when you start pulling money out of those qualified accounts in your 60's and beyond. When you start withdrawing (or do Roth conversions), those transactions will have an effect on (1) increasing your overall tax rate, (2) tax owed on Social Security benefits and (3) possibly increasing Medicare premiums. The questions are: how big of an effect and what can you do about it?
Let's take a step back and see how a person could get into this dilemma. You contribute large amounts of money into a pre-tax retirement account at work over time and/or a Traditional IRA outside of work. You could have done this for many years, maybe two or three decades. It reduced your taxes at the time and helped you build up capital for your future needs. That is the good news, but the bill will come due.
At some point you will withdraw that money and pay taxes on it. You can delay this, but ultimately, the required minimum distribution will kick in. It could be 70.5, 72, 73, or 75 based on your age. How much will it be? It will be close to 4% of your total amount (expect slight differences based on age and gender). If that is a big number, the time bomb could go off! Let's take a look at an example.
A single person has $900,000 in qualified accounts. The RMD is roughly $36,000. That income will be added to Social Security benefits and brokerage income, part time work income, pension money, etc... Let's say all of that income came to $100,000 ($97,000 is the threshold for 2023). That pushes the person into the 22% federal bracket, taxes the Social Security benefit and Medicare premiums go up. Boom!
How did it happen? Taxes went up because you received more income via the RMD. The federal government wants their taxes and the RMD makes sure they get it. This could have been minimized by pulling from the IRA starting at 55 or 59.5 and/or doing Roth conversions even earlier. The rule of thumb is to make these moves when you can stay within the 12% bracket. See the 2023 federal brackets here.
Social Security gets taxed at the federal level when provisional income increases over thresholds. Those thresholds are low ($25,000 for a single / $32,000 for married filing joint). Learn more here. Minimize by pulling from qualified accounts throughout your 60's and/or doing Roth conversions while waiting on Social Security until 70. The strategy is to have less in qualified amounts and more in Roth accounts.
Medicare premiums go up in 2023 if the total income for a single person is over $97,000 or $194,000 for a married couple. Part B monthly premiums go from $164.90 to $230.80 per person and they go much higher than that with $123,000/$246,000, upping the premiums to $329.70 monthly. Part D premiums go up as well with the higher income. This could have been reduced with the strategies discussed earlier.
The time bomb is very real and you want to be aware of it before it is too late. That time before your RMD kicks in is the opportunity to reduce the impact of the time bomb or possibly eliminate it altogether. Basically, you choose to pay a little extra tax each year so you don't have to pay a bunch more tax later AND get that Social Security benefit taxed and the Medicare premiums raised. This is about planning ahead.
You might think this won't apply to you because your qualified accounts are not that big. Let's say you "only" have $200,000 right now and you are 50. If you work another 10 years, that $200,000 could easily turn into $600,000 or more with contributions going in and then by the time you hit your 70's, you could be well over $1,000,000! It is a good problem to have, but now you have got yourself a time bomb!
Here are more ways to avoid this issue? When investing in your retirement plan at work, consider investing 50% to 100% of your contributions via Rothrather than Traditional. The Roth money does not have an RMD and the time bomb issue becomes mute. Most plans nowadays offer the Roth option and it is worth considering paying some tax upfront to avoid the time bomb later.
As mentioned earlier, live off your Traditional money when you retire after 55 (rule of 55 can work for many people, but not all) as you delay Social Security. This reduces the impact of the time bomb and increases the size of the Social Security benefit for the rest of your life. An ideal scenario might have you getting a very large Social Security benefit at 70 and most or all of your money is in a Roth IRA or brokerage.
That Roth conversion strategy is a no-brainer while you are in the 12% bracket. It gets more complicated when you enter the 22% bracket or higher. I personally would pay the federal government 12% voluntarily, I would not do it at 22%. Some of you might. Speak to an accountant if you think it is worth exploring. If you are 55 or older, none of that Traditional money will be taxed in Iowa starting in 2023.
Here is a possible remedy if you are at the RMD stage. You could have your custodian (let's say Vanguard) cut a check to your favorite 501(c) and they will send it to you and then you send it to the 501(c). This avoids the tax on the distribution, provides a possible tax deduction and reduces the effects of the time bomb right now. You could do a donor advised fund. There usually is a limit to get it opened.
Here is one more option. You could do a longevity annuity with IRA money. For example, you could take $200,000 at 70, and buy a longevity annuity that will start paying off at a later date (let's say it starts at 80). This eliminates any RMDs on that $200,000, which could help you in the short term with the time bomb and in the long run if you live a very long time. If you die early, the insurance company is the winner.
Here is one final option that many of you will not want, but for some, it could work. You keep working and you move all or most of your qualified accounts into that 401(k) that you contribute to at that workplace. You will not be required to take that RMD until you stop working and stop contributing to that 401(k). The question is, do you really want to work into your 70's and beyond? If yes, this could be an option.
Let's wrap this up. To reduce/eliminate the the time bomb, it is wise to pull money from qualified accounts prior to hitting your RMD. You can use that money for living expenses or do Roth conversions if you don't need it. Doing it in the 12% bracket is wise. Doing it in the higher brackets is questionable. Once you hit the RMD, your options are much more limited. Plan ahead, there is a great deal of money at stake!
