Tax-Timing Your Retirement

This column is for probably no more than one of your clients: a highly paid partner in a big firm who is still working after age 72 and who has a big chunk of money in the firm’s retirement plan. This tax-oriented worker has postponed taking required minimum distributions from the company plan past the normal start date of age 72. He is not required to start taking RMDs yet because he is still working and is not a “5% owner” of the employer firm.

Just to review the requirement: For an IRA, the IRA owner’s first “distribution year” (year for which an RMD is required) is the year he turns age 72 (age 70½ if born before July 1, 1949). The deadline for taking that first RMD is April 1 of the following year—that is, the year he reaches age 73. That deadline is called the “required beginning date.” So, the IRA owner can take that first-year RMD either in the year he reaches age 72 or in the first three months of the following year. If he chooses to postpone his age-72-year RMD into his age-73-year, he will have two RMDs for the age-73-year.

The starting date for RMDs is slightly different for a qualified retirement plan (such as a 401(k) plan) for an employee who is not a “5% owner” of the employer company: It is April 1 of the year after the employee turns age 72 (just like for an IRA)—or, if later, April 1 of the year after “the calendar year in which the employee retires.” The first distribution year for an employee who is not a 5% owner is the year he turns age 72 or, if later, the year he retires.

“Wyatt,” who is turning age 77 in 2022, is a partner in a big consulting firm. He has about $8 million in the firm’s 401(k) plan, all pretax money. He even rolled over his IRA into the company plan the year before he would have had to start taking RMDs from the IRA, in order to continue deferring that income. He is not a “5% owner”; he’s a partner, but his share of assets and income is less than 5% at the applicable testing date).

Now he is thinking about retiring from his firm at the end of this year. For the first time, he is facing the reality of RMDs from an $8 million retirement account at age 77. He asks: If he retires as of the end of 2022, when must he take his first RMD: in 2022 or 2023?

He does not want to take an RMD in 2022 because he will still be receiving a substantial paycheck from the firm this year. If an RMD is piled on top of that paycheck, it will be taxed at the highest bracket. So, he wants to defer the start of RMDs into 2023.

His expectation is that he’ll retire at the end of 2022 and start RMDs in 2023. His only “paycheck” from the firm next year and in future years will be the modest lifetime guaranteed payout for long-term partners after they leave general partner status, so Wyatt and his wife should be in a somewhat lower bracket and better able to absorb an RMD. Their other income consists of Social Security and investment income.

The projected RMD for 2023 for his account would be about $379,000, arrived at as follows: $8 million retirement account balance, divided by 21.1, which is the factor from the new IRS “Uniform Lifetime Table” for an individual turning age 73 (Wyatt’s age on his 2023 birthday).

Wyatt’s plan raises the following question: If Wyatt “retires” at the end of 2022, in what year does he “retire?” Is it 2022—the last year he worked? Or 2023—the first year he will no longer have his title of general/equity partner of the firm?

Strangely, the IRS has never answered this question. In fact, the Treasury has never defined “retirement” for purposes of this Code section beyond specifying that it means retiring from employment with the employer that maintains the plan.

The conservative bet would be that retiring at the end of December 2022 is a retirement “in” the year 2022, meaning that Wyatt’s first distribution year would be 2022, not 2023. That would trigger an RMD for 2022. Of course, he could postpone the 2022 distribution until January, February, or March of 2023 (the deadline is April 1, 2023), but doing so would mean he would have two RMDs in calendar-year 2023 (the 2023 RMD plus the postponed 2022 RMD). The gross income generated by a double RMD would be close to or exceed $700,000. He would be right back in the highest income tax bracket.

He now realizes the only safe way to avoid this prospect is to postpone his retirement into 2023, then “retire” as early as possible in the calendar-year 2023. That way, 2023 will be his first distribution year. He can take the 2023 RMD in 2023, and since there will be very little income from the firm in 2023, the taxable income should be more manageable.

If Wyatt’s firm were fine with changing his official retirement date to, say, Jan. 15, 2023, and continuing to keep him “on the payroll” with no change in his title, compensation rate, hours, duties, and so on, until that date, there would obviously be no problem with Wyatt’s plan. But that’s probably not going to happen: The firm is moving ahead with removing Wyatt from active partnership to “emeritus” (limited or retired partner) status at the end of this year. The firm is not easily able to arrange a major shift in a partner’s status otherwise than at the end of the year.

What if the employee who is “retiring” on a certain date stays on the books but in a different capacity (for example, as an “employee” instead of “partner”)? In my opinion, if he is still performing services for (and drawing compensation of some kind from) the employer that maintains the retirement plan, he should not be considered “retired” for purposes of the RMD rules. That cautious opinion is subject to the following considerations and limitations:

• The parties must be careful to observe whatever standard has been used to determine “retired” status heretofore with respect to the firm’s retirement plan. The retirement plan may define “retirement” as something short of what constitutes “separation from service.” For example, the firm’s 401(k) plan might provide benefits starting when a full-time employee over a certain age switches to part-time work. It would appear unwise to ignore the definition of “retirement” in the very plan from which the RMDs would be required—if the plan contains such a definition.
• Sometimes an employee who is “retiring” or otherwise terminating employee status keeps up a service-providing relationship with the company as an independent contractor. Switching from working as an employee to “independent contractor” status would almost certainly be considered “retirement” for purposes of the minimum distribution rules. Even though the individual is still performing work for this company, his employer is now himself, not the “employer maintaining the plan.”
• The individual who claims to be not “retired” presumably must be performing services for, and receiving compensation from, the employer that maintains the retirement plan (not counting compensation that is paid to him as an “independent contractor”).
• If the ongoing compensation being paid to the individual is something akin to a pension or deferred compensation (in other words, it is a payment he would receive whether or not he performed services), that would be more consistent with “retired” status than with not-yet-retired status and the situation requires careful study.

The last bullet above describes Wyatt’s position with his firm. Based on the general terms of the firm’s partnership agreement, he theoretically could just retire and disappear at the close of business in 2022 and receive his firm’s nonqualified pension (a guaranteed partnership-income share for long-term partners when they become inactive) in 2023 without performing one minute of work in 2023.

However, the fact that he starts receiving this pensionlike guaranteed share in 2023 should not be considered proof that he is “retired.” As is common with service partnerships, each professional’s transition from full active partnership status to “complete” retirement is different. Wyatt’s firm in fact expects and requires partners to assist with client transition and with completion of matters they worked on regardless of whether such assistance is needed before or after the professional has transitioned from active partner to guaranteed-share status. The firm will continue to pay professional dues and malpractice insurance premiums and keep office space available for a former partner as long as this transition period requires. These ongoing services are part of the reason the “retired” partner receives the guaranteed payments. In fact, the firm’s accountant keeps track of which “retired” partners are actually still performing services, because those partners will have their guaranteed payments treated (and reported) as self-employment income for tax purposes. Only a truly inactive partner who is performing no services is entitled to receive the annual partnership payout without being subject to self-employment taxes.

If Wyatt and his firm appropriately document his ongoing services after the change in his title and compensation, it would appear he can support the status of “not yet retired” for purposes of the firm’s 401(k) plan and time his “retirement” for a later time when his transition services are completed. That’s my reaction—but remember, there is no “authority” on this question.

Conclusion: For all those who are working hard after age 72, keep up the good work! But don’t forget to look ahead at the effect of postponing those RMDs into old age, and make a plan for how to eventually start taking that money out of your retirement plan.

Natalie Choate is a lawyer in Wellesley, Massachusetts, who concentrates in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is a leading resource for professionals in this field. The views expressed in this article do not necessarily reflect the views of Morningstar.