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If you haven’t yet noticed, we like to discuss first world problems here at Physician on FIRE, and the “RMD problem” is definitely one of them.
What is this problem, exactly? It’s the fear that setting aside too much money in tax-deferred retirement accounts will one day lead to having to withdraw very large sums of money from the account(s) as dictated by the required minimum distribution formula.
Withdraw too much and you’ll use up all the lower tax brackets, ending up with taxable income in the upper marginal tax brackets, which, for most high-income earners, is where you took the deduction when you made those tax-deferred contributions.
How likely is to to have a true RMD problem? And how much money does it take? What’s the remedy? Dr. Jim Dahle addresses your questions. This post was originally published by The White Coat Investor.
Your “RMD Problem” That Isn’t: Understanding Required Minimum Distributions
I’ve now run into a misunderstanding enough times that I think it’s worth writing a post about it. I call this misunderstanding “Inappropriate Fear of Required Minimum Distributions (RMDs)”.
It is when the fear that your RMDs will be large and cause you a large tax burden in retirement causes you to make a bad financial move. In this post, I’ll discuss RMDs, what an appropriate response is if you truly will have an “RMD Problem,” and why the inappropriate responses are wrong.
What Is a Required Minimum Distribution?
Starting at age 72, you have to start taking money out of your tax-deferred accounts like 401(k)s and IRAs. Technically, RMDs also apply to inherited IRAs prior to age 72.
They also apply to Roth 401(k)s, but since they do not apply to Roth IRAs, the easy solution there is to roll the Roth 401(k) over to a Roth IRA. Voila — no more RMDs.
At age 72, the RMD is about 3.6% of the nest egg. That’s amazingly similar to what you actually WANT to pull out of your retirement accounts and spend based on a 4% withdrawal rate unless you plan to be the richest person in the graveyard.
As time goes on, those RMDs go up as a percentage of your account. By the time you’re 90, the percentage is 8.8% of the current nest egg.
However, that is quite likely very similar to 4% of the original nest egg adjusted for inflation. In fact, just taking out your RMD and spending it is a completely reasonable way to spend down your nest egg in a safe way.
Bear in mind, of course, that an RMD need not be spent. You can simply pull the money out of your IRA, pay the tax on it, and invest the rest in a taxable account. Nobody is making you spend it.
Also, bear in mind, if you are a high-income professional, that you likely saved 32-37% or more when you put that money in and you are likely pulling it out at rates of 0-24%. Saving at 37% and paying at an effective rate of 15% is a winning combination, even if the tax bill is larger on an absolute basis due to a few decades of compounding.
The RMD “Problem”
Now, let’s describe the RMD “problem”. A true RMD problem is someone who will actually pay taxes at a higher rate upon withdrawal than they paid during their peak earning years. If ever there were a first world problem, this would be it.
If your RMD at age 72 is 3.6% of your nest egg, and your peak earnings years marginal federal tax rate is 37% (like mine is), how large would your tax-deferred account have to be in order for you to pay 37% on ANY of your RMD?
Let’s give you the benefit of the doubt and say you have $100K of other taxable income from your taxable account and Social Security.
The top tax bracket starts at a taxable income of $600K (married). Let’s say a gross income of $700K to make things easy and $100K worth of deductions. Subtract out another $100K worth of taxable account and Social Security income, leaving $500K coming as an RMD.
$500K/3.6% = $13.9 Million.
In today’s dollars.
That’s right. You may need an IRA of nearly $14M in order to have this first world problem. (Remember that’s in today’s dollars since the brackets are adjusted for inflation.) And that’s just for the marginal tax rate to EQUAL your current marginal tax rate. The effective tax rate in the future would still be less than your current marginal tax rate as that entire $500K wouldn’t be taxed at 37%.
My point is that this is a problem that only super savers are going to have. You’re not going to have it with a $1M IRA and a $36K RMD.
I mean, how much do you have to save a year at 5% real over 40 years to get $14M? About $110K. A year. For 40 years. And not spend any of it. Most of us don’t even have access to $110K in tax-deferred contributions.
This is all a first world problem, of course. Assuming no change in the tax code, the only way you’re going to be paying taxes at a higher rate than you paid during your peak earnings years is if you have more taxable income in retirement than you had during your peak earnings years.
May we all be cursed with this problem. When you combine it with the usually dramatically lower expenses of retirement, it’s going to be a heck of a party. Even with significant tax rate increases, if you do the math most are STILL going to be better off deferring taxes during their peak earning years.
The Solution to RMD Problems
Now, for the benefit of those rare people who will have a true RMD problem (who admittedly are concentrated in places like this website), let me describe the solution.
The solution is to do Roth conversions.
A Roth conversion is basically taking tax-deferred money and taxable money and moving them together into a tax-free account. So you might take $50K of tax-deferred money and convert it to a Roth and pay $20K in taxes.
In essence, you’re taking $50K of tax-deferred money (actually $30K in post-tax money) and $20K of taxable money and putting it into a Roth IRA. Now there are no more RMDs. If you recognize this is a problem you’ll have, you can even do Roth 401(k) contributions as you go along and then move that money into a Roth IRA before age 72.
This solution allows your money to continue to grow in a tax-protected manner, eliminates RMDs, provides even more asset protection than you had previously (because some of the money was in taxable), facilitates estate planning through the use of beneficiaries, and allows the use of a Stretch Roth IRA.
Another possible solution for those who are charitably inclined is to give tax-deferred money to charities in lieu of cash (Qualified Charitable Distributions). While you don’t get the usual tax deduction too, you don’t have to pay taxes on the charitable contribution and don’t have to take an RMD, so that’s really the same thing.
This solution also works in a similar way for those who are able to do Roth conversions at a relatively low rate in their 50s and 60s after early retirement, even if they don’t have a true RMD problem.
What NOT to Do with an RMD Problem
So now that we’ve pointed out what reasonable solutions are, let’s point out two things you should NOT do.
#1 Pull All Your Money Out Now
The solution is NOT to pull all the money out of your 401(k) now, pay the taxes and penalties, and reinvest it in taxable. This solution is generally advocated by someone who wants to sell you something, like whole life insurance.
It’s stupid. Not only do you pay the penalties, pay taxes at the highest possible rate, lose the asset protection benefits and lose the estate planning benefits, but you also lose the benefit of that tax-protected compounding for the rest of your life and that of your heirs. And you probably end up with a crummy investment.
It’s idiotic. Really, really dumb. Don’t do that.
# 2 Avoid Making Tax-Deferred Contributions
The second bad solution, although not as bad as the first, is the one I hear about more often by people who are trying to do the right thing. They quit contributing to a tax-deferred account in the first place and invest in taxable instead.
The only reason to EVER pass up a tax-deferred account during your peak earnings years is if you have some investment opportunity that promises much higher returns than something you could buy in the tax-deferred account and you don’t have the money to do both.
Minimizing RMDs is NOT a good reason to avoid maxing out that account.
Contribute $50K in the 401(k) + Convert $50K in the IRA to a Roth IRA = Contribute $50K to the Roth IRA
The reason why is that you can simply do a Roth conversion. You might not be able to do a Roth conversion of that money right then due to 401(k) rules. But you can probably do it later. Or you could do what is essentially the same thing in the same tax year by converting a DIFFERENT tax-deferred account. Money is fungible, you see.
Why would anyone choose to invest in taxable when they could invest in a Roth account? It makes no sense whatsoever. But that is what you are doing when you choose to invest in taxable instead of a tax-deferred account due to inappropriate fear of RMDs.
What do you think? Agree? Disagree? Why do you think people do dumb things to avoid RMDs?
36 thoughts on “Your “RMD Problem” That Isn’t: Understanding Required Minimum Distributions”
As others have pointed out, you make no mention of the potential Medicare surcharge that would be due if the RMD pushes you over the threshold. Perhaps you’re assuming that your readers are already going to be over that threshold, but any discussion about the consequnces of RMDs needs to include the Medicare factor.
PoF,
Thank you for an excellent, informative and educational post. I hope you can provide insight into my situation:
I am 68 and my wife is 66. When I reach 70 in late 2022 I will start drawing on a pension, SS based on my earning history and my wife’s spousal benefit for a total of around $9K per month, pre-tax. This will more than cover our living/fixed expenses.
Our savings are distributed as follows: 82% in traditional IRAs, 2% in Roth IRAs and 16% in non-retirement savings. The RMD tax tsunami when I reach 72 is an unpleasant reality.
It is inevitable and I see no way of dodging it.
I have not been able to justify a Roth conversion.
As indicated in your post, since I have enjoyed over 40 years of tax free growth, do I have to just bite the bullet and be resigned to paying 25 to 30% of my RMDs for tax? Or are there any strategies you recommend?
I would recommend a meeting with a tax professional who can better model what your RMDs will be and what strategies might be available to mitigate the damage.
You say you haven’t been able to justify Roth conversions — are you filling up the 24% tax bracket? If not, I would convert as much as you can to reach a taxable income of $326,600 (the top of the 24% bracket in 2020) and do that annually until you reach 72. But there may be more to your situation that a CPA or tax adviser can sort out.
You have about 6 weeks left in 2020, so I would set something up soon.
Best,
-PoF
PoF, here is a simple illustration of why I am convinced that a Roth conversion is not the most efficient:
Lets say I am looking at converting $100K. My tax bracket is 24%, Return on Investment is 5% and the period for evaluation is 20 years.
Scenario 1: I pay the Roth conversion tax from the converted amount. The Future Value of $76K in the Roth IRA is $201,650.63.
Scenario 2: Pay the Roth conversion tax from non-retirement funds. The Future Value of the $100K converted amount is $265,329.77. But I have also experienced an opportunity cost of the FV of $24K which is $50,600.91 which would leave me a net of $214,728.86.
Scenario 3: Do not convert. The $100K grows to $265,329.77 tax free plus the $24K that would have been paid under Scenario 2 would grow to $50,600.91, after tax, for a total of $315,930.68. Yes the RMD withdrawals have to begin but the tax has to be paid on just the RMD amount and the balance continues to grow tax free.
What if scenarios can be calculated for different ROIs, tax rates and periods. But the uncertainty of not knowing what ROI and tax rates will be in the future, a safer bet would be to not convert.
The end result is going to vary by individual and assumptions about returns and tax rates, tax drag, etc…
If that $315,931 is inherited by a son or daughter in their prime earning years, it could be cut by 40% or more, and now it’s worth less than $200k.
It’s smart to run different scenarios, using the most likely scenario for your situation.
Best,
-PoF
Thanks PoF,
I wish I could retire sooner, but if I hang on till 55, I get paid for medical for my family, and when Medicare kicks in, the Village’s plan acts like a supplement.
It’s hard to pass up, considering it will insure my kids till they are 26 at no cost.
I like your idea of doing the Roth conversions before we potentially hit the 32% bracket, but what are your thoughts on if I should continue with the Roth 457’s and 403b? Or should I switch back to the tax deferred version of these plans.
My gut is telling me if I switch back to the tax deferred plans, I’m potentially creating a bigger tax burden down the road. I know it’s difficult to predict without a crystal ball, and I thank you for your help!
Nico
If you’re willing to hang on to 55, I would. Just don’t do anything dangerous in your final week before retiring like every movie and television cop!
The paid medical is huge, and as long as you are with your employer until the year in which you turn 55, you’ll be able to access the 401(k) directly rather than only having the option of Roth conversions. You could simply make withdrawals if and when you have needs, and still with lots of room in the 24% bracket (which may look different if 5 years, of course).
And I’d keep with the Roth contributions now, as you are in the 24% bracket.
Cheers!
-PoF
After maxing out my 457, my wife’s 403b and her 457 on a pre tax basis since 1997, we began contributing to the Roth version in those accounts in 2020.
We should’ve contributed to the Roth’s in 1997 when we earned less, but that didn’t occur to me then.
Here is why I switched to the Roth’s in 2020 and I’d like your opinions if you think I did the right thing or if I switch back to the pretax version in those accounts.
Here is our situation.
I am a police officer and she is a teacher. We will both have pensions, that we will collect at 55. I am 50 and she is 46.
We live in Illinois and we currently earn approximately $200,000 combined in W2 income. Our taxable accounts generate an additional $15,000 in 1099 Income, mostly short term gains from our VTSAX holdings.
We take the standard deduction on our Federal return, and pay Illinois 4.95% in state income tax.
We currently have $1,153,500.00 in tax deferred accounts (2-457’s and 1-403b). And $1,386,500 in taxable accounts. ALL of it is in VTSAX except for about 20k in a money market fund for emergency cash.
Due to having pensions, we stayed 100% invested in VTSAX since about 2005 and don’t plan on ever changing this since we probably wont need this money, as our pensions will suffice. And we would like to leave our three kids an inheritance.
When I turn 55 in five years, I’ll have a monthly pension of $7,551 / $90,612 annually with 3% COLA’s every year thereafter.
When my wife turns 55, her pension will be $5,303 monthly / $63,640 annually with 3% COLA’s every year thereafter.
When I turn 72 and RMD’s kick in for me, and my wife is 68, our pension income will be around $225,283.00, this is 17 years after I start collecting my pension at 55.
My concern is that our tax deferred accounts of $1,153,500 that are 100% invested in VTSAX and will remain that way, could potentially cause us an RMD problem with 17 years of additional growth.
What do you guys think? Thanks for any in put.
Nico
I think you’re in amazing shape. Well done!
With $1.15M in tax-deferred and 22 years ’til you’re 72, expect that the money invested could possibly double 2 to 3 times (suggesting returns of about 6% to 10% based on the Rule of 72). That would give you $4.6M to $9.2M. There is obviously a wider range of outcomes possible, but that’s a reasonably optimistic look.
3.6% of the high end of that range, when combined with your generous pensions (assuming Illinois can keep its promise, which is a big IF), could put you into the top brackets.
But keep in mind, if you both retire early, you should have space in the low to medium brackets to do Roth conversions. Today, you can have up to $326,600 of taxable income before leaving the 24% federal income tax bracket for the 32%. I’d use the years from retirement to RMD time to do some Roth conversions.
Since you are now in the 24% bracket, I think Roth contributions make good sense. If you were in the 32% bracket, I might do things differently.
Cheers and congrats on your success!
-PoF
Great point about the charitable contribution. The added bonus is that you keep gross income lower bc you did not take as income, which helps also keep medicare premiums reduced.
A secondary component as a result of changes in tax law is that your non-spouse heirs of tax deferred accounts have increased tax liability due to the 10 year rule now. So even if the effect of Roth conversions is nominal to you directly, it will greatly assist those heirs in getting more of YOUR hard saved money and less to Uncle Sam.
For sure. It’s a bit of a bummer that the recipient of the Roth money has to clear out the account within 10 years, but they won’t pay any tax when they do.
QCDs are a great way to deal with RMDs, too. I wonder if the $100k limit will be raised or eliminated at some point.
Cheers!
-PoF
I realize I am not the usual but in addition to doing Roth conversions I’m taking advantage of the current cost segregation rules to move $ out of IRA to purchase income producing real estate and using the bonus depreciation to create paper losses to offset the distributions and avoid paying taxes on them. That strategy has already saved me hundreds of thousands in taxes.
Hmmm. Intriguing. Would you mind expanding on that a bit?
Cost segregation studies allow for depreciation of about 25-28% of the purchase price of apartments. I put down 25% and take a 75% LTV loan. The 25% equity is a distribution from the IRA (over 59 1/2 so no penalty). The current tax law that starts to sunset in 2023 allows for that 25% depreciation to be taken entirely in the first year so the paper loss offsets the Distribution and no tax is owed. This works if you are an active real estate investor but not if passive.
I assume you’re also claiming Real Estate Professional Status when filing, correct?
That allows you to offset active income with passive losses. The caveat is that you (or your spouse) must be able to show 750+ hours of material participation in real estate activity and have it be your primary business.
Take advantage of this while you can! I believe the bonus depreciation where you take a big chunk of it up front may be slated to go away in 2023. Obviously subject to change based on new legislation.
Best,
-PoF
Ok, true for those is the top tax bracket now, but what if you arent and will likely be in a higher bracket in retirement? Examples include- large pensions, widowers, super savers with access to large tax deferred space (457, 401k, 403b, etc).
I’m hedging a little by putting just enough into my roth 401k and the rest in my traditional to keep me in the 24% fed bracket. But, I suspect to be in a higher bracket in a few years (married—> single, wife has cancer). Once I hit higher brackets, I will switch to 100% traditional 401k savings. I find its more the middle brackets (not the top) where the decision and fear of RMDs come into play.
I think what you’re doing is smart, and I am very sorry to hear about your wife’s diagnosis.
I think choosing Roth in the middle brackets makes sense, not so much to avoid big RMDs some day, but due to a lower likelihood of being in a lower tax bracket in retirement, especially in a case like yours.
Best,
-PoF
I am person who is in this situation. I am 52 years old and am receiving a six figure pension. I also have about $800,000 in a 457 def comp plan. Would anyone have an idea if it would be worth it to do roth conversions? I believe I am in the 33% tax bracket.
You may be in the 32% bracket (there is no 33%). If you are single, that bracket starts with a taxable income of $163,301 in 2020. If you’re married filing jointly, double it.
Personally, I would not Roth convert in the 32% bracket, but every situation is different.
Best,
-PoF
I will mention if you are near the 32% bracket cliff check what your MAGI is. This is where I’m actively hovering. But as a single person, I still itemize which does give me about 20k more worth of room than I expected. it’s not a ton but it is something to consider just up to the top of the bracket.
I actually wasn’t aware that I had the room until I talked to my accountant in regards to the next couple of years as my salary will be slightly above the cliff, but upon review it’s not with my MAGI so it still makes sense for me to contribute to my Roth 401k.
It is not the tax consequences per se of the RMD which concerns me, it is the effect they can have on other financial aspects of one’s life. If one is forced to take the money from a 401K thru an RMD then you can hit the tax torpedo on your Social Security — being taxed up to 85% for provisional income above $44,000 for married couples. Further, if the income is too high it can increase what one has to pay for Medicare annual premiums and Medicare Part D.
From my understanding, one could take much more out of a Roth IRA or a savings account and not be subjected to such additional costs in retirement
I expect you, me, and most readers of this blog can expect to have provisional income above $44,000. Unless you’re aiming for leanFIRE or have nearly all of your money in Roth and (not-too-large) brokerage acccounts, you can expect to eclipse that mark in most cases.
Savings accounts don’t pay squat right now, and rarely give you that much more than the rate of inflation. Plus, the interest is taxed at ordinary income tax rates.
Obviously, the Roth money will be tax-free and will not count as taxable income when withdrawn.
Cheers!
PoF
Prior to age 65, I do think it makes sense to shoot for a Zero federal income tax, and that’s an easier target, even for the well-off.
See The Taxman Leaveth.
Cheers!
-PoF
PoF,
That was an excellent post. I want to be Dr Benson!!
That’s why I read your posts!
David
I think this issue is underappreciated. I am Roth converting what I can now up to the top of the 24% bracket. I am retired. The other thing that you can do is put a significant portion of your bond position into your tax deferred space. You still get the “ballast effect” on your total portfolio and the ability to tax loss harvest stocks from your taxable account. Your tax deferred space does not double every 7 years by doing this however. This is just what I am doing. I think about this but there is no reason to do anything stupid just be aware. Another consideration is that doing Roth conversions above 65 will raise your Part B & D medicare premiums. Of course large RMDs will also raise these premiums. There is no free lunch.
You’re playing the game wisely. Hatton1 (where’d the 1 go?). I also have 100% of my bond allocation in tax-deferred retirement accounts.
If I were fully retired, I’d also be converting to Roth as you are. For now, I’ve got income filling up much of those brackets, but I don’t expect that won’t be the case forever.
Cheers!
-PoF
I went back to my maiden name. I have some Muni bonds in my taxable also. You should have number of years to do conversions.
LOL @ Hatton
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While I don’t likely have an “RMD problem,” I am taking steps to mitigate them. About 2 years ago, I switched to the ROTH 401k option, I hover just under the 24% tax rate limit with deductions and I still max it out plus send a good chunk to my taxable account every month. If I had left it traditional, I might have sent the extra $5k I spend in taxes now to my taxable account, or I might have spent it. I’ll call it forced saving in the same way many normal people see their houses as forced savings.
I also plan to roll over money from my traditional balance to my Roth from my ER age of 48 to 72 in a tax efficient manner.
In reality, unless taxes on the upper middle class expand greatly, each of these things is probably a wash but they make me feel “smart”
I think the 24% bracket is a reasonable place to make Roth contributions in lieu of tax-deferred. When you step into the 32% bracket with marginal earnings, that’s where I’d still opt for traditional, tax-deferred contribtuions.
With 24 years to do Roth conversions (based on current tax code), you could move a ton of money out of tax-deferred in the low-to-medium brackets over that timeframe.
Cheers!
-PoF
Ah, Jim and his first world problems. I have suggested that the White Coat Investor will find that he has a RMD problem when he eventually retires. And since he is a consummate tax-efficient investor, he will find this a big problem and change his tune! He plans one heck of a retirement, after all!
https://www.whitecoatinvestor.com/how-to-optimize-your-money-in-retirement/
He is a rare bird. Not many couples socking away six figures into 401(k)s and more into a cash balance plan. But, yes, an “RMD problem” may very well be in his future.
Cheers!
-PoF
Hi,
These are helpful. How would you assess the IRD problem we have in relation to RMD created by the Secure Act?
And in reading other comments, after- tax 401k (not Roth) might be helpful to readers in getting $30-$35,000 a year into Roth after traditional or Roth contributions to reach the $57k plus catch-up allowed into 401k plans from all sources.
Thanks,
Tad
The “Mega Backdoor Roth” is a great option for those whose plans allow for it (non-deductible contributions followed by Roth conversion).
Thanks for another great post. Although I agree that it’s not a problem of living retirement in poverty I think there are a few ways in which this understates the RMD problem:
1. Because it’s happening at age 72+ it is likely to hit couples at a time one spouse passes away and the widow finds herself suddenly in a higher tax bracket. Sometimes it’s better to have that 401K pass to someone other than the widow in order to avoid the excess tax effect.
2. My understanding is the Qualified Charity Distribution is only available for up to $100,000 of the distribution.
3. The Wealthy Accountant takes a more aggressive approach to working to avoid the problem. He recommends thinking about the likely outcome if you are 50 and have a $2 million pre-tax retirement account because if it keeps doubling at a historical rate of every 7 years (even without new contributions) you have both the problem of more of your estate being taxed while you are alive and of leaving your heirs a 401K as inheritance instead of more tax-favorable taxable accounts which get their basis reset and don’t have the 10 year RMD problem. He recommends shifting focus to taxable account investing in addition to the steps you mentioned (Roth conversions, etc.).
Excellent points. You are correct on the $100k for the QCD and the fact that income tax brackets change drastically when going from 2 people to 1 is something to consider, particularly if the surviving spouse is the intended beneficiary of a 401(k) or IRA.
I don’t know that I’d use a doubling every 7 years as a guideline as that suggests 2 things, neither of which are all that likely. One is that the retiree is 100% invested in stocks in the tax-deferred account. Two is that past returns are mirrored in the future.
A more conservative approach is probably best for planning purposes (doubling every 10 to 14 years suggesting returns of about 5% to 7%) and that may be wishful thinking depending on the allocation.
Best,
-PoF