Avoiding An RMD Tax Time Surprise

By Susan Rupe

As the 2018 income tax filing season heads down its final stretch, many Americans are finding themselves with surprise tax bills. One area that can lead to unwanted surprises come tax season is required minimum distributions.

A recent study by Allianz Life found many Americans are concerned about understanding and managing the impacts on taxes resulting from taking their RMDs on retirement accounts such as IRAs.

The vast majority (95 percent) of high-net-worth consumers polled said it is very important to minimize their tax burden in retirement, yet nearly a third (32 percent) say they have difficulty understanding how RMDs could impact their overall tax obligation. More than 80 percent of consumers said they hate paying taxes on their RMDs that come out of most tax-deferred retirement plans, which are calculated as income tax.

Why is it so difficult for consumers to understand the impact of taxes on their RMDs? It comes down to changing focus from accumulating money in a qualified account such as an IRA to focusing on the impact of taxes as funds are withdrawn in retirement, said Kelly LaVigne, Allianz Life vice president of advanced markets.

“When it comes to RMDs, what we don’t prepare our clients for is that, as the RMD percentage grows as clients get older, it can sometimes bump them up into a higher tax bracket,” he said.

A common thought in financial planning, LaVigne said, is that retirement money that has a cost basis or capital gains tax attached to it should be withdrawn ahead of money in qualified accounts such as IRAs. “Because you want that qualified money to grow tax-deferred for as long as possible and use that tax deferral to your advantage,” he said.

But what clients and their advisors may not recognize, he said, is that clients end up having a higher portion of qualified money – taxable money – in their retirement portfolios than any other type of account.

“When they start taking out those larger distributions, they do tend to put themselves in a higher tax bracket even though when they retired they thought their tax exposure would go down because they would need less income. But even though they might need less income, the IRS said they have to take more out of their IRAs.”

One-Third Have No Plan

The Allianz Life survey showed that about one-third of those polled did not have a plan to address the tax implications of taking RMDs.

As advisor help their clients avoid a nasty tax surprise over their RMDs, LaVigne named a few issues to consider.

If clients are retiring in the 64-65 age bracket, which LaVigne said is about the average age of retirement for most Americans, you have a period of between five and seven years in which clients are retired and aren’t required to start taking RMDs.

“If we do have this time bracket and we do have a large qualified account, usually the first response from our clients is, ‘I want to take my Social Security now because I want to take it out when I retire, that’s what it’s there for,'" he said.

“But we know you get delayed credits from for waiting to take Social Security later, so why not put that off. Start taking distributions from a large IRA – yes, it’s taxable, so you’re paying taxes on it a little bit early, but by doing this, your client can use that period of time to lower the balance on their IRA so that when you finally retire, their distribution will be much less and not throw them into the next tax bracket.”

He said advisors can manage this by monitoring the client’s tax brackets. “If they’re in the 22 percent bracket, for example, you could fill up that bracket with distributions from their IRA or a Roth conversion from a traditional to a Roth IRA during that period. Then they have less exposure to higher taxes later,” he said.

Female clients need their own set of advice about RMDs and taxes, mainly because of their greater longevity, he said.

“On average in this country, women marry men who are four years older than they are. And women have a four-year longer life expectancy than men. So we are looking at women living in widowhood about eight years after their husbands pass away,” he said. “The issue with that from a tax standpoint is, we often look at married filing jointly as the category most often used to figure out marginal tax rates. When a spouse dies, that surviving spouse has a much lower margin. So suddenly, even if you have less Social Security, you are in a higher tax bracket much sooner and you are exposed to higher taxes all throughout that time.”

Advisors should work with clients to devise a plan before the client begins taking RMDs, LaVigne said. “Plan to spread out investments,” he said. “Make sure, for instance, if the client wants a legacy account, to make that account into a separate section. You can set aside a portion of the IRA for beneficiaries and invest it as if it is for the beneficiaries.”

Susan Rupe is managing editor for InsuranceNewsNet. She formerly served as communications director for an insurance agents' association and was an award-winning newspaper reporter and editor. Contact her at [email protected]. Follow her on Twitter @INNsusan.