Delaying RMDs may be a costly tax strategy

No pain, no gain. That’s true in most things, since we often don’t like to pay up front for anything that could be put off until a later time. Unfortunately, that can also be true for paying taxes on retirement distributions. This goes for those with 401(k)s (and other company plans) and IRAs, and also for retirement account beneficiaries.

In SECURE 2.0, Congress once again raised the RMD (required minimum distribution) age to 73, from 72 and 70½ before that. That was welcome news, but not for the right reasons. Most people immediately embraced this change because it meant they could delay RMDs for a while longer. But that’s not the right way to look at it.

Simply delaying withdrawals only causes the tax problem to snowball. The better way to use this delay is to take voluntary (unrequired) distributions before RMDs kick in. Then, pay some of those future taxes now at discounted tax rates and convert those funds to Roth IRAs where they will grow income tax free for life and 10 years beyond to beneficiaries.

Use the extra years before RMDs begin to move funds out of IRAs while tax rates are low and can be controlled. Once RMDs begin, taxes will be due, making it more difficult to control tax rates.

When RMDs kick in at age 73, the Roth advantage on those funds is lost, because RMDs can never be converted (i.e., rolled over) to Roth IRAs. The first dollars withdrawn from an IRA for an IRA owner who is subject to RMDs are deemed to be allocated to the RMD and cannot be converted. Once the RMD amount is satisfied for the year, then any or all of the remaining IRA balance can be converted. But this will cost more in taxes because the tax on the RMD had to be paid, and those funds were not eligible for Roth conversion.

In addition to taking unrequired distributions and doing Roth conversions, another tax-saving strategy is to do QCDs (qualified charitable distributions) after age 70½. For those who give to charity anyway, IRA funds can be transferred to charity at a zero tax cost before RMDs are due to lower IRA balances (and therefore future RMDs). Once RMDs are due, QCDs can offset otherwise taxable RMD income.

Delaying RMDs from a 401(k) or other employer plan

Most 401(k)s allow RMDs to be delayed beyond age 73 and until the employee retires; this is the “still working” exception. It applies only to the RMD of the plan of the employer the employee is still working for and only if the employee does not own more than 5 percent of the company (essentially excluding the self-employed). It does not apply to other company plans and never to IRAs. IRA RMDs must be taken even if the IRA owner is still working.

The same logic (avoiding the long-term tax cost of delaying RMDs) can apply here as well. But this entails a different distribution strategy: delaying RMDs from the plan using the still-working exception but taking RMDs (and more) from the IRA. Any IRA distributions in excess of the IRA RMD can then be converted to use up any amounts of lower tax brackets that may otherwise go unused. The company plan funds can stay in the 401(k) while the employee continues to work.

If the employee has no IRA funds to withdraw from and there are low brackets that have not been fully used, then it could pay to take withdrawals from the plan earlier than required (i.e., not use the still-working exception).

IRA beneficiaries subject to the 10-year rule

IRA beneficiaries subject to the 10-year rule would also be wise to take voluntary distributions over the 10-year term even if not required, rather than stand by and wait for the tidal wave of taxation in year 10, when the entire remaining inherited IRA balance must be withdrawn.

Spreading distributions over the 10 years can smooth out the overall tax bill by taking advantage of lower tax brackets for each of the 10 years, rather than getting the benefit of only one year of those brackets. Any low tax bracket not used to its fullest is lost forever. There is no credit for future years.

Back in April, IRS issued Notice 2024-35 waiving 2024 RMDs for beneficiaries who were originally subject to annual RMDs for years 1–9 of the 10-year term.

Read more: Once again, IRS waives RMDs for beneficiaries subject to the 10-year rule

Again, this may sound like good news, but beneficiaries who take advantage of the waiver will likely be accumulating a hefty tax bill, since more of those inherited IRA funds will have to come out in a shorter window.

Advisors should look ahead at projected income and tax rates and identify clients and beneficiaries who might benefit from taking IRA and plan distributions before they are required, allowing better long-term tax planning by controlling tax rates.

Delaying RMDs sounds good now, but the tax bill will continue to compound. Paying taxes on retirement account distributions now will pay off with big tax-free gains later.  If tax rates increase in the future, tax-free funds will be that much more valuable. The overall tax pain can be substantially minimized by taking more distributions now. No pain, no gain.

For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop,please visit www.IRAhelp.com.