Congress has recently expanded a tax trap that affects individuals with traditional IRA and 401(k) accounts by enacting the SECURE Act 2.0 in December 2024. This law has pushed back the age at which required minimum distributions (RMDs) must begin, delaying it to age 73 starting from January 1, 2023. Subsequently, the starting age will increase to 75 starting from January 1, 2033.
If you already take RMDs before 2023, these changes do not impact you. Those who turned 72 on or before 2024 will follow the RMD rules in place at the beginning of 2024. For individuals who turn 72 in 2024, their first RMD must be taken by April 1, 2023, and their second RMD by December 31, 2023, unless they qualify for an exception.
For those who turn 72 in 2023, their first RMD will be for 2024 (when they turn 73) and can be taken as late as April 1, 2025. Individuals who turn 73 between 2023 and 2032 will have a starting age of 73 for RMDs, and their first RMD must be taken no later than April 1 of the year following the year they turn 73. Finally, the starting age for RMDs for individuals who turn 74 after December 31, 2032, will be 75.
Alternatively, one can view it as follows: the starting age for RMDs is 73 for those born from 1951 to 1959 and 75 for those born in 1960 or later.
The question now arises: should you delay RMDs simply because the law allows it? For many people, the answer is “no.” While the general rule of tax planning advises delaying tax payments for as long as possible, this may not be the most effective strategy for reducing lifetime and family income taxes.
Several potential risks are associated with leaving assets in a traditional IRA or 401(k) for as long as legally permitted. Distributions from these retirement accounts are subject to ordinary income tax rates, even if the assets within the account have been generating long-term capital gains or other tax-advantaged income. It might be more advantageous to withdraw the funds early, pay the taxes, and invest the after-tax amount to benefit from tax-advantaged gains and income.
Another risk is the possibility of an increase in your income tax rate. While it was previously assumed that income tax rates decline after retirement, this is no longer the case for many retirees. Many individuals remain in the same tax bracket or even move up to a higher bracket after retiring.
In addition, the Tax Cuts and Jobs Act expires in 2025. If Congress does not take action, tax rates will revert to pre-2018 levels. Alternatively, Congress may raise taxes to address budget deficits and cover outstanding debt.
Retirees face additional risks through what are known as “Stealth Taxes,” which either directly target retirees or disproportionately affect them compared to other taxpayers. These Stealth Taxes include Social Security benefits in gross income, the Medicare premium surtax (IRMAA), and the 3.8% surtax on net investment income.
The mechanics behind the computation of RMDs further exacerbate these risks. Once RMDs commence, the percentage of the IRA that must be distributed and taxed each year increases annually, even if the value of the IRA declines. Delaying distributions will likely cause the IRA’s value to grow, increasing future RMDs. By bunching RMDs from a higher-value IRA into fewer years, you may pay higher income taxes over your lifetime.
Furthermore, delaying distributions can create tax complications for your children or other heirs. Beneficiaries who inherit traditional IRAs and 401(k)s must pay income taxes on their distributions, just like the original account owner. Essentially, beneficiaries only inherit the after-tax value of the retirement accounts, and that value depends on their tax bracket.
It’s important to remember that the original SECURE Act, passed in 2019, eliminated the Stretch IRA. Thus, beneficiaries of inherited retirement accounts are no longer able to stretch distributions over their lifetimes. Instead, most beneficiaries must distribute the entire IRA within ten years. Under the SECURE Act, these distribution rules generally result in higher taxes on the inherited IRA since the distributions are condensed into a shorter timeframe. Additionally, the long-term benefits of tax-deferred compounding within an IRA are eliminated. When the IRA owner delays distributions and minimizes taxes, higher tax burdens will likely be passed on to beneficiaries.
Instead of allowing Congress and the IRS to dictate your IRA distribution strategy, it’s crucial to consider the income taxes you and your heirs will have to pay on retirement account distributions. Compare your lifetime taxes under different scenarios and determine the optimal strategy.
To make an informed decision, running the numbers and analyzing the results over the long term is essential. To help you with this analysis, you can use software programs or use the services of a financial planner.
Many studies and projections by experts have consistently concluded that it often makes sense to begin spending from IRAs and other traditional retirement accounts earlier than required to defer claiming Social Security benefits. Additionally, it is beneficial for many individuals to start withdrawing from traditional IRAs before being compelled to take RMDs.
The advantage of the SECURE Act 2.0 is that it provides a longer period for effective planning by delaying the beginning age for RMDs. Most individuals retire in their early to mid-sixties and may choose to delay claiming Social Security benefits until age 70. During this extended period, they may have no earned income and be in relatively low tax brackets. This allows them to have some control over their income taxes until they claim Social Security benefits and are required to take RMDs.
Take advantage of this window of opportunity to implement long-term tax reduction strategies and plan for retirement cash flow. Consider all possible scenarios and their impact on your lifetime taxes and your family’s taxes after inheriting your accounts.
In summary, evaluate your IRA distribution strategy proactively and consider the long-term tax implications for yourself and your beneficiaries. Make informed decisions based on careful analysis and seek professional guidance if needed.