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Unintended Consequence of Delaying IRA Distributions

By Richard J. Schillig, CLU, ChFC, LUTCF
Independent Insurance and Financial Advisor

In the pursuit of retirement savings, individuals often strive toward maximum “pre-tax” retirement plan contributions and delay of traditional IRA distributions. Eventually, however, withdrawals must be made through the form of required minimum distributions (RMDs) starting by April 1 of the year after one reaches age 70½, and taxes must be paid. Requirement continues annually with RMDs taken by December 31 following first year. For some taxpayers, the strategy of delaying traditional IRA distributions could result in more taxes than necessary.

Since every situation is different, this analysis is a bit tricky, but there are a few issues and planning concepts to think about. Remember I am not a tax consultant. I do not prepare income tax returns or offer tax advice. I encourage you to consult with knowledgeable tax and legal professional who can help identify and implement appropriate strategies for your situation.

But let’s look at a couple important items in dealing with taxes. Changes in tax law, the impact of inflation, IRA fees and costs, and risks of underlying funding vehicles may have a significant impact on the long-term value of an IRA and the amount of tax due.

As a starting point, let’s just say that, generally, the more taxable income an individual has, the more tax they will pay. As their taxable income increases they can be exposed to higher income tax brackets (currently in 2018 the income tax brackets are (Married filing jointly) 10 percent, 12 percent, 24 percent, 32 percent, 35 percent, 37 percent. Let’s look at two hypothetical scenarios where tax surprises could be waiting:

For retirement plans and arrangements like traditional IRAs, 401(k)s, and 403(b)s, the owners or participants must begin distributions at some point – typically at age 70½. And it’s easy to think the best strategy is always to wait as long as possible before taking withdrawals. However, if an individual defers as much as possible for as long as possible, when withdrawals are eventually “forced,” they may end up paying tax on these withdrawals at higher income tax brackets if amount of RMD creates a higher rate of tax.

In addition to the increasing marginal income tax rates there are certain points – usually based on adjusted gross income (AGI) – at which other taxes and costs arrive.

Medicare Part B premiums – The cost of Medicare Part B premium depends on an individual’s income. In 2018, a first-time Part B beneficiary in the first income band (modified adjusted gross income (MAGI) less than $85,000 single; $170,000 for married, filing jointly (MFJ)) has a premium of $134.00/month. If the MAGI were between $85,000 and $107,000 ($170,000 and $214,000 for MFJ) the 2017 premium would be $187.50/month – 40% more

The timing and sources of income are important when planning for retirement. The following strategies and considerations could play an important role in managing taxes.

Roth IRA – If the withdrawal is a qualified distribution, there is no income tax. Any conversions distributed – including those done as rollovers to Roth IRAs from employer retirement plans – may be subject to an additional 10% federal tax for early distributions.

Social Security – Delaying Social Security in the early years of retirement might create an opportunity to remove money from retirement plans at lower income tax rates. In addition to lower initial tax rates, this strategy would reduce the mandatory distribution amounts later on since it would reduce the amount in the plan.

Deferred nonqualified annuities – Since nonqualified annuities don’t have required minimum distributions, they may be appropriate for money that’s not in a retirement plan. This could reduce taxable income and create opportunity to withdraw more from the retirement plans at lower tax rates.

Non-Qualified Immediate annuities – Income is subject to the exclusion ratio allowing minimal income tax for a portion of funds.

Health savings accounts (HSA) – Before starting Medicare, the health savings account allows pre-tax contributions, and tax-free distributions for qualified medical expenses. Pre-tax HSA deposits and their growth can be used to pay one’s Medicare Part B costs in retirement without subjecting the distribution to income taxes.

As the amount of money in retirement arrangements increases, more individuals may end up with tax concerns in retirement. It is very important to plan ahead in order to create the most efficient withdrawal strategy.