By Dr. James M. Dahle, WCI Founder
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 the Required Minimum Distribution?
A Required Minimum Distribution (RMD) is the amount required to be withdrawn annually from retirement accounts each year.
Required Minimum Distribution Age
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.
The Secure Act 2.0 law that was passed in 2022, though, has moved back the year you need to start taking RMDs to age 73, beginning in 2023. In 2033, the age will increase to 75.
In the first year you have to take it, 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.
Can I Reinvest My Required Minimum Distribution?
Yes, an RMD does not need to 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% 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.
How Do I Calculate My Required Minimum Distribution?
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 in 2021 starts at a taxable income of $628K (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%.
Just another first-world problem.
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.
Now you don't have to have a $14M IRA to be a super saver. If you are in the 24% tax bracket in your working years and will be in the 35% bracket during retirement, you're still a supersaver. You may also find if your spouse dies long before you that you can have a higher marginal tax rate in retirement due to having to use the single tax brackets. For example, in 2021 the 32% tax bracket starts at a taxable income of just $164K for singles.
This is all a first-world problem, of course. For the most part, assuming no (or little) 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 earnings years.
How to Avoid Taxes on RMDs
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.
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.
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.
If you can foresee this problem during your peak earnings years, you can even do Roth contributions where available into Roth 401(k)s and Roth IRAs (usually via the Backdoor Process).
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.
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.
Contribute $50K in the 401(k) + Convert $50K in the IRA to a Roth IRA = Contribute $50K to the Roth IRA
Why would anyone choose to invest in taxable when they could invest in a Roth account? It rarely makes sense. But that is exactly 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? Comment below!
I’m the first one to comment! Take that, TPP.
We are likely to have lots of funds tied up in 401k/403b account. Good problem to have.
Hahaha.
I’ve actually missed the top spots for a few weeks now, because I was on nights and then have had two weeks off since then. But I was going strong for the best part of nine months before that 🙂
TPP
You must be on a night shift, or maybe it’s the prednisone. Hope it went well and you can get to sleep today.
Didn’t fall asleep until after 3am (CST). Not on a night shift unfortunately — pretty sure it was the steroid. Got 2 hours of sleep, woke up, dropped kids to school and hopped on a flight to Denver for a conference.
Brought the whole bottle of melatonin with me. Dexamethasone has a long half life…
I have the same issue on prednisone.
I think Roth Ladder conversions do help solve a lot of this problem. It also helps them avoid the other problem that leads people to invest in a taxable account instead of tax protected space – wanting to retire early before age 59.5 and access their funds without getting hit with the 10% penalty for early withdrawals from their retirement accounts.
This definitely is a first world problem, and more of a theoretical problem for most people. My wife and I definitely fall into the super saver category, but we won’t he doing that for forty years… So, the odds that we would get to $14 million are quite small.
TPP
If you’re retiring you can draw out actuarially adjusted (to last over your life expectancy) amounts prior to age 59.5. Might not be enough to cover your needs but certainly needn’t pay whole 10% penalty if you’re getting the money to retire rather than to buy an airplane or something. https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
You can buy an airplane. You just have to do it every year until age 59 1/2.
Definitely first world problem- hopefully one is able to work less as she/he gets past the 10-12M mark, so she/he can enjoy the younger years rather than keep maxing 401k’s, and if the market goes bananas, you know when to stop playing the game. At 4% safe withdrawal, you’d be well above spending 300K a year. As WCI likes to say, most of us have a spending problem, not a saving problem. This hypothetical person may have both!
Charitable donation is always a nice fallback for those that hadn’t planned on it.
So is the title a Blue Oyster Cult reference or a Metallica reference?
Definitely Blue Oyster Cult, but I like the Metallica version too.
Well, in that case, “More cowbell.”
I have yet to hear a song that couldn’t use more cowbell.
Unless you are currently approaching 70 years old, I think it might be very hard to estimate a) what the tax code will look like that far in the future and b) if changes to any of these tax deferred programs will be made by congress.
I would suspect changes to both of these and thus plans will need to be updated as you approach needing to take RMD’s.
The best estimate is the current tax code but I agree that some sort of change is likely. Hard to know which way though. It’s a bit like interest rates. Everyone always says they’re going up…then they go down.
Of course plans will need to be updated.
Here are some interesting links on the history of the 401K and IRA contribution limits.
https://dqydj.com/the-complete-history-of-the-401k-contribution-limit/
https://dqydj.com/history-of-contributions-ira-limit/
Since congress restricted the degree to which the 401K is a tax shelter in 1982 and 1986’s tax reforms and upped the contribution limit in 2001, there really hasn’t been much of a change. Likewise, other than the Roth being created in 1997, not much changed on the IRA front for 30+ years. Catch up limits were introduced to both in the early 2000’s.
The Feds wants their tax revenue and they don’t let you get away without that in any of these programs. That isn’t going to change. Playing the tax planning game of shifting, deferring or converting income is hard to due decades in advance.
In 2014 and again in 2017, plans were floated to “Rothify” the 401k. In 2014 they considered only allowing the first half of the employee and employer contributions to be tax free. Long story short, these things may change and for those of us in our 40’s, I think knowing how the dollars will be treated in 30 years is a tricky game to play and I would just take the tax deferral for as long as Uncle Sam is giving it to us.
Personally, I have always liked the idea of deferring the income with the 401K/403b/457, primarily because I would rather not pay the taxes now and not be subject to the political whims. Obviously there are major advantages to the Roth and tax free growth/withdrawals; however, this is a personal decision for everyone. Knowing the pros and cons of the options and seeing how it fits with your plans is the key.
Some people worry about Roth IRAs getting taxed twice. Something to be said for getting your deduction now.
I am thinking and hoping that RMDs will be changed from 72 age 74.
That’s a strange thing to hope for given nobody is talking about it. But…
https://www.youtube.com/watch?v=QXTpAGVuQi0
Our 401k plan offers both a Roth and a traditional option.
In the very beginning I did not know which one to choose so I kind of hedged my bets and contributed equally to both. Then I realized what you have pointed out about tax arbitrage and now solely contribute to the 401k traditional. I had been contributing to the Roth 401k with the then highest tax margin of 39.6% and figured that the odds were in my favor that the tax bracket I would be in would be lower in retirement.
Also with my plan to retire early (early 50’s likely), I figure I have almost 2 decades to do a Roth conversion and move likely the majority of my money into Roth accounts and pay minimal tax if I can be in the lowest tax brackets with careful withdrawal planning.
As the percentage of employed physicians goes up I think this will be less of a problem. As an employee I only have very limited access to tax deferred space that I cannot access before 59 1/2. This is what tipped me into using our 457 plan. It offers more tax deferred space but I can get it out in case of early retirement.
WCI has covered this:
https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
I have written several blog posts about this over at my blog doctoroffinancemd.com. The first about this is http://doctoroffinancemd.com/2018/03/15/rmd-rmd-why-do-i-care/ I certainly do not advocate ever taking money out of retirement accounts except when used for retirement. In your peak earning years fill these up to the legal limit. As you start to slow down and are not in the max bracket then conversions make a lot of sense. FWIW Roth accounts were unavailable to me earlier in my investing life. I started small conversions as I started working part time. Since I recently took a part-time job at my local hospital I am using the Roth 401K option. I will roll this over when I retire. This makes since for me because I am not in my peak earning years and will not work long enough to vest in matching funds. Everyone talks about lower taxes in retirement but you need to tweak your account diversity to achieve this.
How did you calculate the roth is the better option for you now? I thought I might be in a similar situation but even though my income is drastically reduced I’m still in the 35% marginal bracket (single, over 200k income). even if tax rates go up quite a bit the avg rate upon withdrawal should be lower then that, right?
As this article is primarily for the 1%’ers you might want to be aware of IRMAA-Income Related Monthly Adjustment Amount. This is the Medicare surcharge for retirees who have income exceeding $750000. It is a sneaky subsidy reduction that increases Medicare Parts B and D by around $400 a month PER PERSON -$800 per couple. The average retiree pays $134 a month for Medicare but the 1%’ers will pay another $321 per month (plus Part D surcharge). I have a sneaking suspicion that Congress will do something similar to Social Security as well. No one will shed a tear for those paying this surcharge but money in a Roth or life insurance cash value will not count for this income level-so a vote for Roth if it is feasible. Do people even know about IRMAA? Ask your financial advisor.
$750K a year in retirement? Maybe IRMAA apply to all of us.
The increase kicks in at $170000 ($85000 for single filers) which includes SS benefits so I am sure many docs will be “asked to contribute”.
Kind of amazing that people are worried about Social Security being means-tested when it already is in at least three ways.
Yes. Just means there will be a 4th then.
Another consideration is to look at the projected taxable income and tax after the death of one spouse when the surviving spouse has to pay tax at the single rates rather than the joint filers rates. After reviewing this in my own situation (semi retired age 64 married with low 7 figure taxable IRA) I am considering being more aggressive with Roth conversions (being willing to pay now at the 22-24% rate rather than only up to the top of the 12% bracket). Obviously market returns and tax law are unknown in the near to medium term. But my best projections suggest that in my case limiting conversions to the 12% bracket just doesn’t do enough to limit the tax exposure in out older years. In addition to more aggressive Roth conversions, we are also looking at delaying social security to age 70 and converting even more aggressively in a market downturn.
Thanks! Hadn’t gamed this possibility- new thing to worry about/ factor in to our Roth conversion decisions.
“…Converting even more aggressively in a market downturn.” How does locking in a loss help? Isn’t this putting the tax cart before the total return horse?
You just pay the taxes with funds outside your IRA. It worked out well for me in 09. I had a traditional IRA that was cut in half after the crash converted it all to Roth IRA paid the tax bill at a fellows salary and now have a nice Roth IRA with ability to do back door Roth every year.
You’re not locking it in. You own the same number of shares. But it costs you less in taxes to move them from tax-deferred to tax-free.
Ah, right. I got fixated on the conversion as a sale rather than a transfer. Thanks!
RMDs are an argument for keeping bond allocations in tax-deferred accounts. Presumably, these will grow less over time, while assets with higher expected growth can stay in taxable and Roth accounts.
No no. You WANT a larger tax deferred account over taxable. Think of a tax-deferred account as a Roth account plus an account you invest for the government. The larger the account, the larger the Roth portion (i.e. the portion that is really yours.) Tax-protected and asset-protected growth is a good thing. Why would you want less of it?
It’s not quite either or. Highest growth in real Roth. Taxable gains come out at cap gains preferred rate though this can vary depending on overall income. In your scenario the proportion of “pseudo-Roth” vs govt share depends on your tax bracket at withdrawal, no? At higher end of the wealth curve the overall income may be high enough that high RMDs push tax bracket on everything. If income can be managed at lower levels can avoid taxes
Not sure what you mean “It’s not quite either or.” Nor can I decipher most of the rest of your comment. Don’t let the tax tail wag the investment dog. The easiest way to have low taxes is to have low income, but that’s not exactly the goal here. The goal is to have the most after-tax. The way to do that is to help your money grow faster by taking advantage of tax protected accounts whenever possible. That means both funding them and growing them as quickly as you can. With tax location, you are weighing tax-efficiency of the asset class (which argues for most efficient asset in taxable) against expected return of the asset class (with highest returning asset in the tax protected account.)
You can put highest growth in a Roth IRA and expect higher returns overall by doing so. But the reason your expected returns are higher is that you’re taking on more risk. You’re putting more of your portfolio, on an after-tax basis, into a riskier asset class.
This post should help:
https://www.whitecoatinvestor.com/my-two-asset-location-pet-peeves/
I regret my cryptic reply. I don’t really disagree, only pointing out that I think there may be exceptions to your argument. Agree that maximizing tax-deferred savings is needed, asset allocation is driven by investment philosophy and that high growth overall is desirable. Also, agree one is ideally aiming for high income, but only trying to manage the taxable portion. Your example is obviously correct, and shows a relatively low income situation. But if you drive the income/spending to a high wealth level–say you want to spend 400k a year and your Tax-deferred savings is >3m (for example)–the argument gets messier. It is a question of how growth is stored until you need to pay taxes. Stored growth is tax free in Roth, and comes out as ordinary income in Tax-deferred and as LTCG in taxable. At high incomes, RMDs push the tax brackets up, while withdrawing from Taxable savings offers more options for managing taxable income, in that you may have capital loss offsets, or relatively sluggish gainers to harvest first.
I agree, as your tax-deferred account gets into the millions, the Roth vs Tax-deferred 401(k) and Roth conversion issues becomes much murkier. Other things also drive the balance toward Roth as discussed in this post:
https://www.whitecoatinvestor.com/should-you-make-roth-or-traditional-401k-contributions/
thanks for spelling out how much you need to have in an IRA to actually have this be an issue.
Recently on Humble Dollar there was a link to a piece Richard Quinn wrote on why he favors Roth 401k/403b contributions in peak earning years over the traditional contributions (https://humbledollar.com/2018/07/pain-postponed/). His argument was that taxes are likely to be higher in the future due to unfunded govt liabilities. Although that is certainly possible, I was having a hard time seeing how it would make sense to give up the guaranteed tax break now when I’m in the top bracket, but your example is helpful to see how much you would need to save (with current tax rates) to actually have this be a problem.
I have a 1% question.
Husband/wife both have sizable tax deferred retirement accounts, AND have enough taxable investment accounts not to require the RMD as a necessity for living expenses.
Should each spouse make their children the beneficiaries of the 401k/IRAs INSTEAD of the other spouse, ie lower tax burden for the family as a whole? what is your opinion?
I read something recently about the importance of putting disclaimers on your 401k/IRA (hopefully when you die you don’t have a 401k and you’ve fully rolled it over to the more-flexible IRA). If you put disclaimers on, it allows the people who are living to decide what to do. Let’s say you die and you leave everything to your spouse. If you have a disclaimer on there, it allows your spouse to refuse to take what you left him/her (or, more importantly, maybe only claim X%) and then the rest goes to contingent beneficiaries. This flexibility seems ideal to me, as we can’t predict the future. Disclaimers give the flexibility of making these decisions for whatever the laws are when you die
It doesn’t work like that. You’ll still owe the taxes. You may need to see an estate planning attorney to minimize taxes at death though.
This truly is a 1% problem. Maybe I’m overthinking this but it really seems more complicated for those of us who are 2 or 3%ers instead of 1%ers. If one is in the high end of the 24% bracket today, let’s say $300k to make it simple, that’s a healthy upper-middle-class/lower-upper-class income. 24% is way different from people in the 1% who are contributing at least 40%, sometimes more than 50% depending on what state they live in. So we’re in the 24% bracket today and if we’re maxing out our tax-deferred retirement accounts for 15-20 years (two 401ks, a 401a, and a 457) those could grow to around $4m or so. Keeping everything else static, that gets you to $144,000 in your first RMD year, and add to that SS. you’re firmly in the 24% bracket still (and the likelihood of a 24% bracket in 20 years or so is very low….I have no idea what it’ll be. So was there a point to doing the conversion? yes, I think long-term there was for your estate planning, but probably not much for you personally. the unknown future makes it harder to more easily see the benefits of converting if you’re in the 24% bracket as opposed to 40%
Yes, the larger the difference between your marginal rate now and your marginal rate later, the more benefit in using a tax-deferred account. But it’s a pretty rare doc who will be in a higher bracket later.
Not necessarily so. I have found tax rates to be quite fluid over my career. When I was a resident(Carter/ Reagan years) My wife and I were in the 40% marginal tax bracket. In retirement, I have found the promise of tax deferral to be somewhat of an illusion. The current federal tax rates are the most generous you will probably have within the next 30 years. My advice to young doctors is “Roth every nickel you can.”
If you’re giving that advice indiscriminately you’re probably hurting more than you’re helping. Even if tax rates in general go up, an individual’s bracket is likely to go down in retirement. That was the point of this post. Look at how large your IRA has to get for you to be in the top bracket in retirement. Very few docs are going to get there. Run the numbers. Then run them again but assume every tax bracket goes up 5%. For a typical doc, you’ll get the same answer (i.e. tax-deferred over Roth during peak earnings years except for the most super of super savers.)
Well, Doctor, to each his own. I see “the bird in the hand” is not tax deferral, but ultralow federal tax rates. This is especially true for physicians still within the 24% federal tax rate. Higher income physicians will often have other streams of income in retirement that drive them into higher tax brackets. With a Roth, you get decades of tax free compounding and guaranteed step up basis. With tax deferred accounts, you were converting your capital gains and dividends to ordinary income, with a silent partner, Uncle Sam. Remember, somebody will eventually have to pay the tax on this account and the government will get its share. But the government has the right to change their share of the proceeds. It is probably best if you have both Roth and tax deferred accounts for tax diversity. I believe in the future, rates are destined to go much higher and a physician would be well advised to “Roth what you can, while you can”. Others may have different opinions.
For the few physicians who can have two 401Ks due to working W2 job and 1099 job, I’ve been mentally battling about how to distribute my pre-tax savings vs my roth savings and I think the Roth conversion will be the main option IF it still exists in 20+ years. My W2 gig fully funds my 401k the full 55K as employer contributions (functions almost like a company profit sharing plan), allowing my 1099 retirement account to have an employee 18.5k and 20% employer contribution (first 25K of earnings is tax free!) Trying to decide whether to put all in tax deferred or divvy up some roth on my side-gig 1099 income or all pre-tax.
Using a future calculator and putting in $55k a year (max tax deferred savings that my company does for me no matter what) – ER doc fresh out of residency. I’m 30s now and lets say I work for 20 years. the FV calculator at 7% inflation adjusted returns turns the pre-tax nest egg to 7MM having my initial RMD to be $270k but could definitely rise as the nest egg gets bigger in 70+ retirement. If any physician is following your guidelines, this does not seem like an impossible goal to achieve and then one will be in a large tax bracket in retirement also. I realize this is a 1% money saver problem but I’m not in the 1% income bracket – i just want to know mathematically what the best answer will be (and try to do that)
I think the answer is do a Roth conversion after I stop working but I think that if I have rental property income or continue to work part-time, I’ll still be in a non-low tax bracket. I wonder if its better to hedge my bets and put in Roth now….
If anyone else has been thinking about this, please let me know your thoughts. thanks
7% is a pretty optimistic/aggressive real return. I’d suggest re-running your numbers with 5% or even 3% real just in case. I wouldn’t even think about starting to worry about it until I had $1M in tax-deferred accounts.
But if you’re convinced you’re going to be a super saver your whole career, then sure, do a little more Roth 401(k) contributions. Either way, it’s not like you’re doing a bad thing. It might just be one thing is slightly better than another.
https://www.whitecoatinvestor.com/should-you-make-roth-or-traditional-401k-contributions/
I thought that if you were to convert retirement account money to a Roth that you had to convert the whole account. Is it possible to convert variable sums each year as you wish?
Yes.
Common misconception that you have to convert all or none. (I didn’t know exactly till I started converting). You can do as little or as much as you want. I have been doing for 4 years. I have a Schwab account and periodically I go online and “convert” specfic shares from my traditional account to my Roth. Schwab moves over the shares instantly. No charge/no commission. They report the conversion which obviously bumps up my ordinary income. You can take baby steps converting. I have learned to convert stocks that are down at year-end and convert them in January for the rebound.
if you have no state income tax the effective rate on 250k of ira income for a couple is less than 20%
there is a calculator which tells you if you should convert ira to roths
nothing wrong with having a huge ira account; it is bliss not having to touch principal possibly never
I am one of those (few?) people whose RMD’s exceed their pre-retirement income. In the pre-Roth era, I fully funded my profit sharing plan and had unexpectedly good stock market returns. When I retired, I rolled all of my pretax accounts into a t-IRA, which is now valued in the high seven digits. I have been taking RMD’s for the past three years, and they now are more than my annual pre-retirement income, and more than my living expenses, even with a child in graduate school. I am paying a considerable amount in taxes, but as has been said, that is a first world problem.
I rest my case. You have a high seven figure tax deferred account. You are a super saver.
Partly retired, and when I realised SS PLUS RMDs PLUS current pension PLUS dividends (we aren’t spending all our dividends- so that’s rising) would have us at higher income, so doing Roth conversions now to max out next income bracket. And as I noted above, hadn’t considered the increase from married to single rates when one of us is widowed. Think if we leave the kids anything Roth IRAs are better things to leave them than regular. As we get older will just put those/ most of those in kids’ or grandkids’ names if we doubt one of us widowed will need the money.
For those who feel the current federal income, cap gains and qualified dividend tax rates are low and will increase in the future, please remember there are many ways government can gain revenue. Even if we assume tax revenue must increase, which while likely, is not a given, it does not mean it will be accomplished via income taxes. The US could take the European route and institute a VAT, without increasing, or perhaps even reducing income taxes. They could also decide to go after generational transfers, returning to aggressive estate taxes. They could go after assets directly and institute a wealth tax, taxing a percentage of net worth yearly. Who knows, as taxing authorities are infinitely creative. Please note I am not advocating any of these approaches, just pointing out that predicting what government will do 5, 10 or 20 years into the future is futile. That’s why I advocate diversification, not only of investment types, but of the account types we hold. By having taxable, tax deferred and tax exempt accounts, we reduce the risk that a change will impact 100% of our savings and gain the chance to engage in arbitrage between accounts.
I think a VAT is exceedingly likely in my working lifetime. Michael Kitces talks about this in one of his posts. Most Americans wouldn’t complain because it’s not taking money from them, just causing insidious price increases in everyday products (which doesn’t show up on a receipt). Furthermore many people seem to think that if Europe is doing something, it must be THE right way of doing it. Unfortunately no good way to shield yourself from this tax that I can think of.
Spend less. I actually prefer to be taxed on my consumption rather than my income. I suspect many savers feel the same way. The big issue, of course, is going from an income based system to a VAT. That would be painful.
VAT in my opinion would be a terrible mistake.
Consumption versus income sounds great… but it would be a trap.
ie, VAT inexorable upward creep… and then for “fairness”, reinstated income tax on the rich.
So we end up with double taxes
any recommendations about what to do with inherited IRA RMDs? my father passed away a few years ago and as an heir i and my sisters split his IRA account. we are all forced to take RMDs because he was older than 70 1/2 at his passing even though we are in our 40s. because i am a high earning doc i am paying a significant tax on the RMD every year. i’ve decided to take the after tax RMD money and put it directly into my kids 529 college fund, but if there is any way to lower the tax burden on the RMD it would be nice.
I don’t think there is anything else to do but pay the taxes. Obviously, don’t take out any more than the RMD.
give it to your sister. no more tax. shake your fist at your father for making you pay this tax.
but seriously, taxes mean you made money, enjoy it and move on.
If you are going to give to charity anyway, you could donate the RMD. The contribution should offset the withdrawal. I can’t think of anything else but to pay the tax.
Interesting but extreme example. What about when one spouse dies and the survivor is paying tax at the single rates?
What about the annually increasing RMD amounts as one ages?
Income and dividends are low now along with low inflation. At more normal levels, say 5% the taxable income alone could be a lot.
Most people have limited tax deferred space so, for high earners, most of their savings are in taxable.
Consider a couple with $10M in taxable, $4M in tax deferred. Assume they stop working at 70. They would have RMDs on the $4M, but at 5% they would have $500k in taxable income on the $10M. Add SS and the RMDs could push them into the top bracket quickly.
$100k of deductions? For what? They probably don’t have a mortgage and SALT prevents high deductions for taxes.
Yes, this is the “tax trap” of too much money in tax deferred accounts. The couple also probably has decades of embedded huge capital gains in the taxable accounts. Having a large portion of the 4 million qualified plan money in a Roth would be wonderful tool for later life planning. A large pot of money that can be accessed without any tax consequences . Gifting to children, grandchildren, trusts, living expenses etc. The couple could leave a modest amount in the tax deferred account that could be used for either charitable legacy or the nursing home.
There’s a cost to all that Roth money. Of course we’d all love tons of Roth money, but it requires you to give something else up to get it and the question is whether it’s worth it.
1. Maybe Roth conversions should be made while two are alive if their ages or health status are significantly misaligned
2. The % increases, but the total amount may not, especially on a real basis.
3. Not sure what makes one level normal and another abnormal. We could be here for decades.
4. Depends. Lots of variability here. I had no taxable account at all until a couple of years ago because I could defer so much (nearly $200K/year)
5. Not sure a couple with $14M is very representative of my audience. But yes, if you are in the range of net worth, consider doing lots more Roth than you’re doing now.
6. Hopefully charity. I know I’d be giving at least that much on $700K of gross retirement income. Add in some property and income taxes of course. But sure, it’s possible it’d only be $24K.
Having it in Roth would be great, but how would they get it there?
They are at a high tax rate while working and after finally retiring. I don’t see them as having a period of low income and low taxes when conversions would be beneficial. Doing Roth conversions while working and in, say, the 35% bracket would not be appealing. Once SS kicks in, even without RMDs while working, they would be at the top bracket. After retirement, depending on prevailing interest and dividend rates they may still at or near the top rate.
Yes,I agree at this point that this couple is pretty much stuck in the tax trap. This is why I say for high income physicians, tax deferral in many cases in later life is an illusion. You have only so much space in qualified plans and I suggest for high income physicians use that money for Roth contributions. If you really want additional tax deferral , you could always use a variable annuity for tax inefficient investments (reits, bonds etc).. But I think you will find these will fall into the tax trap as well. The younger physicians today have a much better opportunity with the mega Roth IRA’s. Many physicians become blinded by the lure of tax deferral, and forget it isn’t tax free. Uncle Sam must be paid. Even at a rate of 37% today, historically this is not unattractive rate. My grandfather in the 50s paid 70%, my father in the 70s paid 50% and I as a resident with with a working spouse paid 42% I know it is painful to pay the taxes, but sometimes it is a wise choice. This would all be so much easier if we could just see a copy of the 2048 tax tables!
As far as contributions, the only choice to be made for most is on a mere $18.5K ($24.5K after 50.) The rest either HAS to be tax-deferred (profit sharing and cash balance) or HAS to be Roth (Backdoor Roth IRA.) Can’t make a huge difference there on a 7 figure IRA. The big money is in the Roth conversions. The Mega Backdoor Roth IRA isn’t available to most physicians.
Good reason to lobby the benefits committee at work to create the Mega Backdoor Roth option for the 401k/403b!
Yeah, but those high rates of yesteryear came with a lot more ways to deduct and exclude income. There used to be deals, legal until they banned them, under which you would “invest” in something and they would hand you a tax deduction worth more to you than the investment you made. Before my time, but apparently this was big in oil and gas exploration. No economic substance to the deals, many existed only on paper. But by using them people could avoid a lot of those high tax rates.
Yes, there were many more deductions and these “tax shelters” were available. However, not all the money could be put into the shelters and income was still taxed at those high marginal rates. The name of the game was taking ordinary income and converting it into capital gains. So investments were made in cattle feeding lots, oil and gas wells, real estate etc. Many of these were sold by shady promoters who offered leverage. 3 to 1 tax write offs for investment principal. These typically would run 3 to 5 years and the risk was that the IRS might look back and declared them to be abusive. The IRS would then subpoena the promoters client list and go back and assess back taxes, interest and penalties. This caused a world of hurt. Many doctors got blown up with these tax shelters. I know of one internist who worked well into his 80s because he couldn’t afford to retire because of a bad tax shelter deal. Sometimes just paying the tax is the simplest solution.
The government has aggressively closed many of the loopholes and tax shelters in the code over the 40-50 years the 401K has existed. The days of renting an empty building as a tax shelter are basically gone — aka the late 1970’s.
They aren’t going to let you get away without paying taxes on pretty much anything — hello “gift tax” limit of 15K a year.
You used to be able to tuck away the equivalent of 70-180K in the 401K when it first came into being — look at the income limit from 1978-1981! Those days are gone.
https://dqydj.com/the-complete-history-of-the-401k-contribution-limit/
The argument over whether a 401K deferral or a Roth tax free withdrawal will go on forever, just like the buy/rent and own/lease and pay down debt/invest arguments. Regardless of how you slice it, you can’t use these vehicles and never pay taxes on the income.
Fidelity has 1% of its total retirement plan participants with a balance in a 401K or IRA over 1 million dollars.
http://awealthofcommonsense.com/2018/07/how-hard-is-it-to-become-a-401k-millionaire/
You are way out on the flat part of the curve with these issues. Not that they aren’t relevant, but there’s only so much you can do with the tax laws the way they are and nobody in congress is crying over the 1% of 401K millionaires.
Agreed, this not a common problem with most people. But this is a board for high income physicians. The RMD tax trap is not an uncommon problem for retired specialty physicians in their 70s and 80s. Many of them wish they had had the option of a Roth in their younger days. Your mileage may vary.
No, it’s a blog for high income professionals such as physicians. That includes lots of people with incomes in the $100-300K range, which I would NOT consider a high income physician.
I would argue that an RMD “tax trap” is a very uncommon problem, even among retired specialty physicians in their 70s. That was the point of this post. Look how much someone would have had to save to get to $14M in today’s dollars? That was a huge chunk of money back in the 70s and 80s and the tax-deferred vehicles really weren’t available or well known or had very large contribution limits.
Well, doctor this is your blog and you are doing fantastic work. I was merely trying to add my prospective of a lifetime in medicine. The RMD problem is quite real within my peer group. I lunch with guys every week with this problem. Maybe my comments are helpful, maybe not. Compound interest over 3-4 decades can supersize a portfolio. Take it for what it is worth. As I said, your mileage may vary. Best of luck to you.
I think you’ve got a pretty elite lunch group!
WCI is definitely right
I am 81 with most of my portfolio in tax deferred
1) I am still compounding the taxes I didn’t pay in the 1970s, 1980s and 1990s.
2) This year my RMD is also going to be equal to my last preretirement pay
The best thing that can happen to you is that the taxes on your RMD go up every year. If they go up a lot that means you are in Fat City and high cotton………..Gordon
WCI,
This article is so right on! In fact I am going to link it from my own articles on Seeking Alpha where I have been drumming this message into members for years.
I see so many people talking about doing Roth conversions during their working years just on what I call the FOMO (fear of missing out) on tax-free income in retirement. At what cost I actually ask?
Many may have missed these important statements in your article:
” Also, bear in mind, if you are a high-income professional, that you likely saved 32-37% 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.”
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?”
The importance of the above is that you typically avoid taxes while you are working at your highest marginal rate, but in retirement you are spending money across multiple tax brackets that are typically lower. These LOWER tax brackets should be filled with your tax-deferred IRA money and your Roth money should be used to avoid the higher tax areas that levy higher taxes on your Medicare premiums and “net investment income” (Nii).
Just one small comment – It’s not exactly like comparing your marginal working rate to your retirement “effective rate.” I was recently reminded that it is really comparing a “marginal” working rate that probably only covers one tax bracket, to a “marginal” retirement rate in which your IRA (tax-deferred) money most likely covers MULTIPLE tax brackets.
As it turns out your taxable account and its dividends and capital gains can also push up your taxable withdrawal rates on your IRA.
Finally, you must consider what is going to happen if you actually succeed in spending down your IRA funds to zero – You will have no IRA money to spend in that zero percent tax bracket!!
Yes, you are correct about the marginal/effective issue. It’s technically marginal vs marginal.
The article accounted for some taxable and SS income.