The Impact of Ignoring Required Minimum Distributions
Many of you throughout your working career have contributed to a tax deferred retirement account, whether that be a 401k, 403b, 457, or even an IRA account. Once you hit a certain age, you’ll be required to take what’s called Required Minimum Distributions that forces you to take money out each and every year and that you have to pay taxes on that distribution.Now, with that responsibility of withdrawing money from your retirement account comes a lot of mistakes that we often see.
So today I want to talk about some of those mistakes that are often overlooked and how you can avoid them. But first, let’s talk about some of the important changes that were made to Required Minimum Distributions back in December of 2022 in The SECURE Act 2.0.
Really, the biggest change was the age at which you begin taking these Required Minimum Distributions. For those that are already taking Required Minimum Distributions or were born before 1950, you will continue to take those Required Minimum Distributions as normal. For those that were born in 1951 to 1959, you will begin taking your Required Minimum Distribution at age 73. And those that were born in 1960 or later, you will begin at age 75.
Common Required Minimum Distribution Mistakes
Now, one of the biggest mistakes with Required Minimum Distributions is simply failing to take your Required Minimum Distribution. Now that may seem simple, but this can result in one of the largest tax penalties in the IRS code, which is 50% of the Required Minimum Distribution amount. Plus all of that distribution is still fully taxable to you on the federal and state level, depending on the state where you live.
Now, the second mistake is understanding how Required Minimum Distributions can impact the amount of tax to pay throughout retirement. So, here’s an example.
Let’s say you’re a young retiree that’s age 60 with $1,000,000 retirement account. Assuming a 4% growth rate, that Required Minimum Distribution will be approximately $60,769. Now, if you’re a retiree that is relying on that income and using all that income for their income plan, then this may not be as relevant. But, let’s say you aren’t needing that income. That could be an additional $60,769 of additional income that you have to pay tax on.
So, without a plan, this can make big impacts on your overall retirement. Now, the IRS calculates the Required Minimum Distribution based on two things, your age and your account balance. So, as you can see on the chart, as you continue to get older and your account continues to get bigger, your Required Minimum Distribution also continues to grow.
Now, let’s say this retiree has other taxable income, things like Social Security and pension, that equals to about $130,000. And that additional Required Minimum Distribution of a taxable income of $60,769, that jumps this retiree from the 22% bracket to the 24% bracket. And since the Required Minimum Distribution continues to get bigger, that means that this retiree will likely be in that higher tax bracket throughout the rest of their retirement.
Now, it may not seem like a big difference from the 22% to 24% bracket, but if you look at all the rest of the tax brackets, there are some significant jumps in the tax brackets. For example, from the 12% to the 22%, is a 10% jump. So, it’s so important to be aware of how your Required Minimum Distribution will impact your tax bracket.
The last mistake is how Required Minimum Distributions will also impact your Medicare premiums. This is an important planning item and oftentimes overlooked by retirees. An increase to Medicare premiums is called IRMAA, which stands for Income Related Monthly Adjustment Amount. Just as the name says, Medicare will adjust your Medicare premiums for Part B and D depending on your amount of total income that you report on your tax return.
How this works is Medicare looks at your income from two years prior, and if your income falls within certain thresholds, that will determine the amount of your monthly Medicare premium. It kind of works like tax brackets, depending on how much income you make, it may be in the 10%, 12%, 22%, 24% bracket, etc..
Now, I’ve listed a couple of common tax filing statuses to show you the different thresholds and brackets for Medicare. For example, let’s say you’re a married couple filing a joint return. If your total income, or in other words, your Modified Adjusted Gross Income falls between $194,000 and $246,000, your Medicare premiums will increase from $164.70 to $230.80 per person, plus your Medicare Part D premiums will also go up by about $12.20.
Now, these brackets do adjust for inflation and may change over time, but this will give you a general idea of where your Medicare premiums will be based on your income. Now, every retiree should be able to have an answer on how they’re going to address Required Minimum Distributions.
Like I mentioned before, some may be relying on all their Required Minimum Distribution for their income, so this may not be as relevant. However, time and time again I have seen so many retirees who have failed to plan for their Required Minimum Distribution and how it will impact them.
There are a lot of different ways you can manage the impact of your Required Minimum Distribution, whether that be through Roth conversions, Qualified Charitable Distributions using a Donor Advised Fund, but simply having a plan allows you to take your Required Minimum Distribution in the most tax efficient way possible.
Carson Johnson is a Certified Financial Planner™ professional at Peterson Wealth Advisors. Carson is also a National Social Security Advisor certificate holder, a Chartered Retirement Planning Counselor™, and holds a bachelor’s degree in Personal Financial Planning and a minor in Finance.