Required Minimum Distributions: How They Work and How to Plan For The Future Taxes | Episode 3

In today's video I talk about Required Minimum Distributions, also known as RMDs. I talk about how they work, when they start and things to think about when it comes to RMDs. The future tax impact that they can have on your plan and your money. I talk through ways to create flexibility in your money to plan for future RMDs. 

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Transcript

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Today I want to talk about something that most of you aren't thinking about because it's 20, 30, 40 years away. And that is required minimum distributions, also known as RMDs. And if you're under the age of 55 or even 60, you're thinking, Colin, what the heck? Why is this something that you're telling me to think about today? And that is a fair question. But this is one of those things that if you understand it now, the more control you can have over it in the future. So what are RMDs? Well, this is the IRS requiring you to take money out of your pre-tax accounts when you hit a certain age. And when you take money out of those pre-tax accounts, the money that you withdraw is taxed as ordinary income rates. Because when you put money into those pre-tax accounts, you're working your pre-tax 401k, your traditional IRA, maybe you have a pre-tax 403B. When you put money in, you didn't pay taxes on that money going in. So when you take it out, your contributions plus any growth that you had on it, everything that you take out in that year is taxed at ordinary income rates. So the IRS says, hey, you're we're gonna require you to take out a portion of your pre-tax accounts every year once you hit a certain age. That is what required minimum distributions are. Now this age isn't like 55 or 60 years old, depending on the year you were born. If you were born before July 1st, 1949, these RMDs start at 70 and a half years old. If you were born between July 1st of 1949 and December 31st of 1950, RMDs are at age 72. If you were born between 1951 and 1959, these RMDs start at 73. And if you were born anytime after 1960, your RMDs start at 75 years old. So for most of you watching this, you're probably in that 73 or 75 age where your RMDs start. So for many years, you started working, you're putting your money into those pre-tax accounts. Now the IRS is saying, hey, we want a piece of the action. We want that tax money that we let you kick the can down the road. So this is where people get tripped up. They say, hey, I want the largest pre-tax retirement account as possible. And while growing your money and having a large balance at retirement is important, but when you build all of your money in a pre-tax account, then you have what's called a future tax problem. Because when RMDs kick in, you don't get to decide how much money you take out. The IRS does. There's a formula that they use to say, depending on the account balance at the end of the year, we're going to require you to take out X amount of dollars out of your IRA or pre-tax account in this year. You have to take it out. And if you don't, we're going to penalize you. And the bigger the account you have, you can guess, the larger your RMD will be. To think of it, let me give you a hypothetical example. Let's say you've done a great job saving over your working career. You've done a lot of saving into your pre-tax accounts, and now you hit 73 years old. You have about 1.5 million in a pre-tax IRA. Let's assume your RMDs kick in at 73 years old. Well, at 1.5 million, your RMD is going to be around $56,000 for the year that you turn $73. And that $56,000 is taxable income to you at ordinary income rates. Whether you need it or not, maybe you only need $40,000, but you have to take out that $56,000 amount. You're $73,000, so you have Social Security coming in. Maybe you have a pension or other income sources. And now you're required to take out $56,000 out of your pre-tax IRA. Again, that is taxed at ordinary income rates to you. And suddenly your tax bracket went from here to here. And that is what people don't see coming. The potential for an increase in tax bracket. Now instead of being in the 22, potentially, you're in the 24, maybe from the 24 to the 32, given current tax rates. So now every dollar you take out at the marginal rate that you jumped up to is more taxes that you're paying on money potentially that you didn't have to take out. But because of the RMD, you were required to take out that amount. So why am I telling you about this? Because before 73, 75, 70 and a half, depending on the year you were born, you might be 55 years old right now. You have time to maybe create flexibility in your financial plan. And after RMDs start, your options are limited. So the longer you have until these RMDs kick in, depending on your situation, you have time to create flexibility. I'm not talking about avoiding taxes altogether. All I'm talking about is being intentional with where you're putting your money or how you're treating your different accounts, whether that's pre-tax, after tax. I'm talking about being intentional with your money. Maybe it means not putting 100% of your current contributions in pre-tax. Maybe it means using Roth accounts also. Maybe it's taking advantage of low income years and using Roth conversions to strategically move money from pre-tax accounts to Roth accounts that will lower your future RMDs. Maybe it's doing qualified charitable distributions, also known as QCDs, to lower your RMD amount. See, the thing is, is there is no one size fits all. What works for one person may or may not work for the next. But the worst strategy is just ignoring it and saying, I'll figure it out later. Oh, I'll take care of that when I get to RMD age. Because again, when you are at RMD age, there is no flexibility. You are required to take out, based on a formula, this much money. The further you are away from RMD age, the more potential you have to create flexibility with your money. For example, Roth accounts, so your Roth 401k, your Roth IRA, they don't have RMDs. So there's no, hey, you are required to take out this much money out of your Roth accounts. It is with these pre-tax accounts that these RMDs kick in. You might have heard this, but when people talk about tax diversification, not diversification within your account, buying US stocks, international stocks, bonds, etc., I'm talking about tax diversification. This is what they're talking about. Creating tax diversification with pre-tax accounts, Roth accounts, and taxable accounts. Creating tax diversification with your money, which creates flexibility. RMDs are a great reminder that tax deferred does not mean tax-free. It just means we're going to defer it down the road to figure out at a later time. And if you start thinking about this today, if you have a large pre-tax account, if you start thinking about this today, 500,000, 800,000, 1 million, 5 million in pre-tax accounts, if you start thinking about this today in your mid to late 50s, maybe even early 60s, you can make smarter decisions leading up to RMD age. So if you've been building up large pre-tax money from 401k or traditional IRA, it might be a good idea to sit down with a financial planner like myself and discuss what your future RMDs may look like and what potential tax planning strategies can you start using today to create flexibility and tax diversification with your money. Because when you get to RMD age, 73, 75, that flexibility diminishes. It might even go away. So getting ahead of the curve on talking about your future RMDs can help you create flexibility in your financial plan. Thank you so much for being here, and I will see you in the next episode. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.