Could Later RMDs Lower Your Tax Bill?

In the wake of the passage of the SECURE Act in 2019's waning days, the "death" of the stretch IRA has grabbed the most attention.

And indeed, the requirement that nonspouse IRA beneficiaries empty out their inherited IRAs within 10 years has seismic implications for financial planning, especially for wealthy families. Whereas in the past a young inheritor--say, a grandchild--had the opportunity to stretch out the tax deferral of the inherited assets by taking required minimum distributions, or RMDs, over his or her lifetime, that withdrawal period is now truncated to just 10 years.

But another provision in the SECURE Act has even more widespread--although perhaps not "seismic"--implications: the increase of the starting age for required minimum distributions from IRA and other tax-deferred accounts from 70 1/2 to 72. That's an acknowledgment of the fact that some Americans are working and living longer and may not need to withdraw from their retirement accounts until later in life. The IRS recently proposed updating the RMD tables to reflect changing life expectancies, also with an eye toward ensuring that retirees don't outlast their savings; those proposed revisions are still under review.

RMD Basics Before we go any further, let's quickly review how RMDs work, whom they affect, and how the rules regarding RMDs are changing. (This article will focus on RMDs by account owners, but the SECURE Act also made changes to RMDs for inherited IRAs.)

First, the what and why of RMDs: Required minimum distributions--mandatory distributions later in life--are in place to ensure that tax-sheltered investment accounts don't skirt taxation in perpetuity. In essence, they're the government saying, "We've given you a free ride with no taxes due on this money through your accumulation years; now it's time for us to take a cut." RMDs apply to tax-deferred accounts such as traditional IRAs, 401(k)s, 457s, and 403(b)s; they also apply to Roth 401(k)s. (From a practical standpoint, RMDs for Roth 401(k)s can be avoided by rolling the funds into a Roth IRA.) The Roth IRA is the sole major retirement savings vehicle not subject to RMDs, though whether that might change is a subject of open debate. As in the past, people who are still actively employed can delay RMDs from their company retirement plan even if they're past RMD age.

What's Changing Prior to the SECURE Act's passage, the so-called "required beginning date" for RMDs hinged on the age 70 1/2; the required beginning date for RMDs was April 1 of the year following the year the account owner turned age 70 1/2. And it's important to note that for people who turned age 70 1/2 in 2019, they must still take their first RMD by April 1, 2020. People who are already taking RMDs are also unaffected by these changes.

For people who weren't yet age 70 1/2 in 2019, the SECURE Act allows them to wait until age 72--or, if they so choose, April 1 of the year after they turn age 72--to take their RMDs. For example, let's say Ted's 70th birthday was Dec. 1, 2019, meaning that he's subject to the new rules for RMDs. (He wasn't yet 70 1/2 in 2019.) He'll turn 72 in December 2021, so he can take his RMD that year or wait all the way until April 2022. Under the old RMD rules, he'd need to take his first RMD in April 2021 at the latest, because he turned 70 1/2 in 2020.

As in the past, anyone waiting to take their first RMD until April 1 of the year after the year in which they celebrated their 72nd birthday will need to take another RMD by Dec. 31 of that same year. For example, let's say Shirley will turn 72 in November 2021. (Like Ted, she's subject to the new RMD rules because she wasn't yet 70 1/2 in 2019.) She can wait until April 1, 2022, to take her first RMD (for her 72nd year), but she'll need to take another by year-end 2022 (for year 73). The tax consequences of having to take two RMDs in a single year could outweigh the benefits that she gains by delaying her first RMD until April.

It's important to note that the required minimum distribution tables will remain the same for the time being, and the person taking a first RMD at age 72 would use the distribution period that corresponds to age 72. Thus, even though RMD start dates are getting pushed out for some IRA owners, they may have to take a larger percentage with their first RMD than they would have if they had taken the first RMD at age 70 1/2. Of course, those RMD tables could change between now and when today's 70 1/2-year-olds turn 72 and are subject to RMDs. Account values are in the mix, too, as RMD amounts correspond to the account's value on Dec. 31 of the year preceding the RMD. For 2020 RMDs, for example, amounts are based on the account's value at year-end 2019.

Are There Any Planning Opportunities? In the end, one of the most basic advantages of the new required beginning date for RMDs is simplification--there's no more worrying about half birthdays to determine whether and when to take RMDs. Additionally, tax-deferred account owners pick up an extra year or more of tax deferral. How much extra time depends on birthdate, as tax-planning guru Jeffrey Levine points out.

One big planning opportunity related to RMDs at 72 is that the SECURE Act leaves the eligible age for qualified charitable distributions, or QCDs, intact at 70 1/2. The QCD gives charitably inclined retirees the opportunity to make tax-free gifts using assets from their tax-deferred accounts. The mismatch between the QCD-eligible age (70 1/2) and the new RMD age (72) provides an opportunity to use QCDs aggressively when first eligible with an eye toward reducing RMDs when they commence. However, there are a couple of limitations to that. First and most obviously, it's a short window. Second, QCDs are limited to $100,000 per year.

Another potential benefit of delayed RMDs to 72 is that it effectively enlarges what Vanguard head of wealth planning research Maria Bruno has called the "sweet spot" for retirement planning--the years following retirement and before RMDs commence. Because the retiree at that life stage is no longer earning a salary and isn't yet subject to RMDs, it affords an opportunity to make adjustments to help reduce taxable income down the line and to do so at a relatively low tax cost.

For example, those post-retirement, pre-RMD years may provide an opportunity to convert a portion of traditional tax-deferred assets to Roth when taxable income--and in turn the tax burden of those conversions--is at a relatively low ebb. That will reduce the amount of assets that are subject to both RMDs and taxes once age 72 arrives. Similarly, "the sweet spot" allows for tax-lowering maneuvers not directly related to the IRA--for example, tax-gain harvesting in taxable accounts while taxable income is at a low ebb can help reduce or eliminate capital gains taxes eventually due on those assets. Check with a financial or tax advisor to gauge whether any of these maneuvers make sense in your situation.

Yet as compelling as these planning maneuvers sound, there are a couple of countervailing forces in play for retirees who can now delay RMDs. The biggie is that most retirees at this life stage are also receiving Social Security (there's no benefit for delaying beyond age 70). So even if they aren't working and aren't yet subject to RMDs, their control over their tax bill isn't as encompassing as it was prior to Social Security. There are also lifestyle considerations in the mix: The early retirement years are often heavy-spending years and arguably they should be, because people are often healthy and have a lot of activities bidding for their time and money. Those lifestyle considerations may limit the extent to which retirees want to keep income low to take advantage of the "sweet spot."