David H. Kinder, RFC®, ChFC, CLU
Myth #16: "I'm going to be in a lower tax bracket when I retire." Understanding RMDs
Updated: Feb 7
This is a common phrase that I hear from traditional planners, advisors, CPAs, and attorneys.
Here's what's interesting about this particular response I got from a prominent attorney in another state.
Read the highlighted section:
"Particularly if somebody feels they will be in a post-retirement lower marginal tax bracket." Feels? Really?
Well, here's a different conversation I had with a high earning gentleman last year. His earnings are around $500,000 a year.
Yet, he wants to retire at $200,000 a year.
That would be at a lower tax bracket right?
First, we need to look at the deductions he probably won't have:
Child tax credit (he had six children, but they are all up, grown, and mostly married off)
Mortgage interest (he plans on having his home paid off)
401(k) or other qualified plan contributions
He believes that $200k a year, with little expenses would be enough for him, even if it was all fully taxable + taxing his Social Security + higher Medicare / IRMAA costs.
He may be right!
However, because of where his money may be (in this example, I'm assuming a 401(k)/IRA), it may not be up to him!
Why? Required Minimum Distributions.
Required Minimum Distributions (or RMD's as they're commonly referred to) is the government's way of saying "Hey, you didn't pay taxes on your salary deferral plan and we want our tax money at today's rates."
So let's look at how to figure out one's RMD.
Below is page 63 of IRS Publication 590-b for IRA distributions.
Now, the current IRS publication is for preparing 2020 tax returns and we've recently had a change in RMD age requirements from age 70 1/2 to age 72. So let's take age 72. The number next to one's age is a divisor. Meaning that you take your plan balance as of the end of the prior year and divide it by the divisor. Let's suppose that this gentleman has $5 million in his 401(k) plan and only wants to take out $200,000 at age 73. Age 73: $5,000,000 divided by 24.7 = $202,429. Pretty close! Here's the problem: That divisor... grows smaller... which means the amount you take out must INCREASE EVERY YEAR!
Let's look 5 years later at age 78 and let's assume that the plan has been managed well and has NOT gone down and kept its balance at $5 million. (Not a likely scenario.)
Age 78: $5,000,000 divided by 20.3 = $246,345
The government is mandating that you take out more and more each year in your retirement.
But... that's not the end of the story is it? Nope.
If your plan balance was managed by an investment advisor representative and would advise you that, due to volatile markets, you should limit yourself to 2.8% of your plan balance each year to have an 85% chance of not running out of money. (See safe withdrawal rate studies by Finke, Blanchette, and Pfau.)
Safe withdrawal rate says this to have an 85% chance of NOT running out of money: $5,000,000 x 2.8% = $140,000
How much does the Government mandate you take out?
See above: $202k and $246k?
Keeping your money in an IRS regulated retirement plan INCREASES your risk of running out of money in retirement, particularly if you are using investment management as your primary way of managing your retirement portfolio.
Of course, if your plan balance is higher, the government wants their "fair share" of that amount each year you must take RMD's.
You can't retire in a lower tax bracket unless it fits the government's plans for your retirement balance. You can't just "take out less" unless "less" is at least the amount the government says you can take out.
Let's also not forget that, if you DON'T take it out, not only do you still owe the TAX on the RMD you should've taken, but you'll pay a 50% penalty for not having taken it!
Would it make sense to explore other alternative ways to manage your retirement so YOU are the primary beneficiary of your wealth and planning and YOU decide what you want to do with your plan?