Navigating the Tax Consequences of Required Minimum Distributions

Retirees taking withdrawals from their portfolios may find themselves navigating taxes and Medicare premiums. Because of this, the traditional advice of draining tax-deferred accounts—like a traditional individual retirement account (IRA)—before taking withdrawals from a Roth IRA may not always be sensible.

The most obvious reason why is federal income taxes. From an investing standpoint, this applies to required minimum distributions (RMDs) from tax-deferred accounts, taxable bond interest, interest on cash savings, short-term capital gains and non-qualified dividends and distributions. Up to 85% of Social Security benefits can also be subject to one’s marginal tax rate. The Medicare Part B premium is based on one’s modified adjusted gross income (MAGI) from two years ago. Then there are separate tax rates for qualified dividends and long-term capital gains.

This mix of taxes adds to the complexity of taking withdrawals. Retirees can navigate them with a bit of understanding and a written plan of action. As part of the Individual Investor Wealth-Building Process (formerly code-named The AAII Way), we are going to help you think through the tax consequences.

We’ll start with tax-deferred accounts subject to RMD rules. These include traditional IRAs, SEP IRAs and 401(k) plan accounts, to name a few. RMDs are taxed at your marginal tax rate and count as income in terms of how much of your Social Security benefits are taxed for the same tax year and for determining what your Medicare Part B premiums will be two years from now. RMDs of up to $100,000 can be offset by making qualified charitable distributions (QCDs) from traditional IRAs and inherited IRAs. Under certain circumstances, QCDs can be made from SEP IRAs and SIMPLE IRAs as well. [RMDs are required from Roth 401(k) accounts but are generally not taxable.]

RMDs are waived for 2020. The starting age for taking RMDs is now 72; it was 70½ for those who reached that age before January 1, 2020. For discussion purposes, we’ll treat the RMD as no longer being waived as is currently expected to be the case in 2021.

The simplest way to avoid having to take RMDs beyond giving those dollars away through QCDs is to convert assets held in tax-deferred retirement accounts to a Roth account. Simplest should be not confused with cheapest. Roth IRA conversions are treated by the tax code as ordinary income in the year they occur. Depending on the amount converted, these conversions could push you into a higher marginal tax bracket. They can also increase the percentage of Social Security benefits taxed and how much you will pay in Medicare Part B premiums two years from now.

Those not deterred by a bit of math and complexity can navigate the tax maze. Limit withdrawals from taxable accounts to the RMD. If more is needed, only withdraw up to the top of your marginal tax rate. Any extra should be taken from your Roth IRA or taxable accounts. On the conversion side, estimate your adjusted gross income (AGI), your modified gross income and your taxable income for the current year. (All three will be influenced by any capital gains realized in taxable accounts as well as by taxable interest income.) The ceiling for the amount to convert will be the difference between your taxable income and the upper limit of your tax bracket.

This ceiling may be lowered if the conversion increases the percentage of Social Security benefits that are taxed from 50% to 85%. The breakpoints are $34,000 for single filers and $44,000 for joint filers. Likewise for Medicare, the ceiling would be the breakpoint above which your Part B premiums will increase two years from now. Current premiums will work as a good enough guide. Keep in mind the Social Security Administration uses combined income (AGI + nontaxable interest + half of your Social Security benefits) while Medicare uses modified adjusted gross income, which is AGI plus tax-exempt interest.

With these numbers in mind, you could create a plan to convert a portion of your IRA to a Roth IRA over a period of time. In doing so, consider if you will be able to postpone withdrawing the money for a period of five years and how your tax rate may change in the future. Roth IRA conversions make the most sense when you expect your current tax rate to be lower in the future than it is now. Estate planning considerations may also a play role, particularly if your heirs’ tax rates are expected to be higher than yours.

Roth IRA conversions aren’t for everyone. A conversion that bumps you into a higher tax bracket and leads to higher Medicare Part B premiums may not be as cost effective. If you are unable to cover the taxes on the conversion with non-IRA dollars, you may need to leave the converted amount invested for many years to compensate for the amount paid out. Those relying on RMDs for living expenses may not see as much benefit either unless their tax bracket is unusually low for a given year. Our Roth IRA conversion worksheet can help you to calculate some of the numbers involved with the decision.