A recent tax article written for Forbes by William Baldwin, How Retirees Pay Zero Taxes, caught my eye. The article discussed how a hypothetical wealthy retired couple could pay no federal tax by putting their wealth into real estate, municipal bonds and stock index funds. The income earned from these investments was either tax-free or was cancelled out by deductions and exemptions. Baldwin interviewed a CPA who confirmed that many of his wealthy retired clients were in this situation.
The article had a lot of fine points, but it was missing one very important piece. Most wealthy investors have considerable savings stashed away in tax-deferred retirement accounts such as traditional IRAs. The IRS won’t allow the money in these accounts to stay tax-deferred forever. They require distributions to start by age 70 ½, and taxes to be paid on the distributions.
The Tax Man cometh to retirees when Required Minimum Distributions (RMDs) begin, and he never leaves. RMDs go straight to your IRS Form 1040 as income from IRA distributions. This gets added to your adjusted gross income (AGI) and taxes are usually owed. The IRA minimum withdrawal rules also apply to simplified employee pension (SEPs), SIMPLE IRAs, and rollover IRA accounts. Roth IRA owners are exempt from the minimum withdrawal rules as long as the original account owner is still living.
Unfortunately, it doesn’t end there. Chances are the RMD will trigger higher Social Security income taxes and a range of other tax items. Taxes on Social Security benefits begin when your AGI and tax-exempt income is above a certain level and go higher as your income increases. We’re still not done. With a higher AGI, you could lose certain tax deductions, which leads to higher total tax owned, and you could be hit with backdoor taxes, such as higher Medicare co-payments.
How much flesh the Tax Man takes from you will depend on your age in the current tax year and the amount of money you had in certain tax-deferred accounts as of previous December 31st. The IRS provides an easy-to-use RMD worksheet on their website.
Let’s look at an example of a RMD based on a hypothetical couple, Joe and Jane. Both are turning age 70 1/2 this year. Ten years ago, the couple retired with an IRA account worth $2 million. They did not take any money out on the advice of their adviser. The account earned 7% per year since retirement, and is now worth $4 million. Through good financial planning described in Mr. Baldwin’s article, they have paid no federal taxes in retirement thus far.
To keep matters simple, let’s assume the couple takes their RMD by December 31 of this year (in the first year they are allowed to wait until April 1 of the following year). The value of their IRA on the previous December 31 was $4 million as discussed. According to the IRS worksheet, the couple must withdraw $145,985 and claim this as ordinary income when filing taxes next April.
If our retired couple was not paying any federal tax before, they’ll likely be paying it now. In addition, they’ll pay more taxes on their Social Security income, pay higher Medicare expenses, and perhaps lose a few other tax benefits.
Right after the couple writes the check to the IRS, they will go back to their adviser to see what can be done. The answer they get will not be encouraging. There are a few minor things, but not much. Some IRA money could be donated directly to charity and this could lower the tax burden. Another idea is the “automatically-10-years-younger-beneficiary rule.” This is when one spouse is designated as the sole IRA beneficiary and he or she is more than 10 years younger. In this scenario, IRA minimum withdrawals use more favorable joint life-expectancy figures based on the actual ages of the two spouses. (However, this isn’t a good option for our couple because they aren’t ready to divorce and remarry younger spouses.)
The adviser shows them their reality. Their expected annual RMD will more than double over the next 20 years and they will owe more taxes each year because of it, as illustrated in Figure 1. The figure is based on the investments in the account earning 5% per year.
Figure 1: RMD from a $4 million account beginning at age 70 1/2 assuming 5% annual gains
Source: Rick Ferri, http://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf
The couple learns that their tax situation will get much worse before it gets better. The RMD amount increases every year until age 92, where it tops out at $329,418 assuming 5% in annual earnings. As they age, they’ll be paying more taxes, losing more deductions, and paying a higher percentage in medical costs as their government benefits diminish.
If you’re a wealthy retired person who is paying no federal taxes and laughing all the way to the bank, be aware that the IRS isn’t far behind. When RMDs from IRAs and other tax-sheltered accounts begin, the Tax Man will cometh…and he never leaves. Please see your tax adviser for advice on your personal situation.
Disclaimer: The information contained in this article does not constitute tax advice. You should consult with a professional tax adviser familiar with your financial situation before making any decisions.