King & Wood, P.A.

Can I Pay Less Taxes on My Retirement Funds?

“You don't get to use all the money in your traditional 401(k) and IRA for retirement because you still have to pay taxes on it.”

No one likes paying taxes on retirement funds. However, unless you have a Roth IRA or SEP, funded with after-tax dollars, you will owe taxes on withdrawals. However, according to a recent article from U.S. News & World Report, “How to Pay Less Tax on Retirement Account Withdrawals,” there are strategies to reduce taxes on your retirement account withdrawals.

Avoid the early withdrawal penalty. If you take money from a traditional IRA before age 59½, the penalty is 10% plus the income tax due on the withdrawal. If you are in a pinch and need the funds, you would be better off taking withdrawals from a 401(k), which is penalty free if you leave the job associated with the 401(k) at age 55 or later. You might be able to avoid the penalty if the money is needed for a large medical bill, college costs or a first home purchase.

Roll over a 401(k) without tax withholding. Changing jobs? If you take money from a 401(k) when you change jobs, 20% is held for income tax. If you do not put the entire distribution directly into a new retirement account, you could end up owing income tax and the early withdrawal penalty. One way to avoid the tax withholding and penalties is to do a direct transfer from your 401(k) to the trustee of another 401(k) or IRA. Trustee-to-trustee transfers are not generally considered a taxable event.

Manage your required minimum distributions. IRA and traditional 401(k) owners are required to take minimum distributions after age 72. Missing an RMD is expensive: the penalty is 50% of the amount you should have withdrawn, plus income taxes. However, if you are still working after age 72 and do not own 5% or more of the company you work for, you can keep delaying those RMDs from a 401(k) account held for you by your employer until you retire. For IRAs, you still have to take those withdrawals.

Be careful about distributions. Plan the distributions for the first year. You do not want to take two distributions and risk getting bumped into a higher tax bracket. The first RMD needs to be taken by April 1 of the year you turn 72 (or 70½ if you were born before July 1, 1949). The second and all subsequent distributions are taken by December 31 each year. If you delay the first distribution until April, you will end up taking two distributions, which could lead to a big tax bill.

Taking withdrawals earlier than age 72. By taking traditional retirement account withdrawals during your 60s, you can spread the tax bill over more years and enjoy the benefits of a lower tax bracket, reducing your overall lifetime tax bill. Try to take 401(k) or IRA withdrawals during a year when your income is low, like after you retire but before you take Social Security benefits.

Consider a qualified charitable distribution made directly from your IRA. Retirees 70½ or older can avoid income taxes on IRA withdrawals of up to $100,000 (or $200,000 per couple), if they make a QCD directly from their IRA to a qualifying charity. You can also donate part of your RMD and withdraw the rest of income.

Keep tax-preferred investments out of retirement accounts. If you have investments generating long-term capital gains in a retirement account, you will pay a typically higher regular income tax rate when you take the funds from the account. By contrast, you can lower the taxes by holding more highly tax investments (like Treasury inflation-protected securities, corporate and government bonds and funds generating short-term capital gains) within retirement accounts.

Balance retirement funds taxes with your overall retirement plan to try to minimize taxes. Do not neglect to discuss tax planning when you sit down with your estate planning attorney to create or revise your estate plan.

Reference: U.S. News & World Report (March 8, 2022) “How to Pay Less Tax on Retirement Account Withdrawals”

How Much Is the Required Minimum Distribution from Retirement Accounts?

“Americans are living longer than they were a generation ago, and the government knows it. Starting in 2022, that will be reflected in the amount of money you have to draw from retirement accounts at different ages.”

The IRS has updated the formulas for Required Minimum Distributions, or RMDs, the amounts required to be taken annually from 401(k)s, 403(b)s, or traditional Individual Retirement Accounts (IRAs) in 2022. According to a recent article from AARP titled “How an IRS Rule Update Impacts Required Minimum Distributions,” the new RMDs will be smaller now than in previous years. RMDs have always been a complicated topic, and now they might just be a little more so.

Getting the calculations right has always been a bit of a muddle. For one thing, in 2020 RMDs were suspended entirely. Before the pandemic, the 2019 SECURE Act changed the age when you had to take withdrawals from 70½ to 72. This was except for people who were already taking RMDs in 2019. Are you confused?

Now, if your 72^nd birthday occurred before July 1, 2021, you need to take an RMD before December 31. However, if your 72^nd birthday takes place in the second half of 2021, you have until April 1, 2022 to take your first withdrawal—only you’ll need to use the 2021 tables from the IRS to calculate it.

A reminder: Roth IRAs do not require any RMDs, but 401(k) Roths do.

Starting in 2022, many people will be able to take about six or seven percent less in their RMD under the life expectancy tables from the IRS. A 75-year-old single woman with an IRA worth $100,000 at the end of 2021 will need to withdraw at least $4,065 in 2022, about $300 less than under prior guidelines.

However, you need to consider whether or not taking less from your IRA or 401(k) or 403(b) is a good idea in the long run. If you need to take more to live on, then you need to withdraw what you need, regardless of the IRS rules. There’s no penalty for taking more, except the taxes you’ll pay.

If you retire before age 70, before any RMDs are required, you might want to withdraw more from your tax-deferred retirement accounts in order to delay taking Social Security benefits. The longer you delay taking Social Security benefits, the larger your monthly payment will be. This is a good move for many Americans, especially those who are counting on Social Security for income in their 80s and 90s.

There isn’t a single person in America (well, maybe there is one) who isn’t frustrated by having to pay taxes on earned income required to be withdrawn from retirement accounts. However, there are ways to blunt the impact of income taxes on IRAs. Those who are older than 70½ can donate to registered 501(c)(3) charities, by making a Qualified Charitable Distribution (QCD), which is counted toward any RMD as the amount of the donation is exempted from income taxes. However, this only works if you take the standard deduction and don’t itemize charitable gifts.

Unless the rules change, converting tax-deferred IRA money into a Roth IRA is a strategy to shift not whether you pay taxes, but when. Converting traditional IRA assets during a low-income year—or a portion of traditional IRA assets—allows the money in the Roth account to continue to grow tax free and no taxes are due on any withdrawals. Unless the laws change—again.

Reference: AARP (Dec. 8, 2021) “How an IRS Rule Update Impacts Required Minimum Distributions”

What Happens If I Take a Bigger RMD?

“Sometimes only taking the minimum IRA distribution can be a costly mistake. When deciding how much to withdraw this year, you need to consider the big picture. For some people, it makes sense to go big.”

Once you celebrate your 72^nd birthday, the IRS requires you to take a minimum amount from IRAs or other tax-deferred retirement accounts. Most people take the minimum, says a recent article from Kiplinger titled “Should You Take an Extra Big RMD This Year?” However, taking the minimum is not always the right strategy.

Looking at the broader picture might lead you to go bigger with your RMDs. For example, Bill and Betty are ages 75 and 71. Bill has an IRA worth $850,000. Their retirement income consists of a pension totalling $34,000, dividends of $8,000 and combined Social Security benefits of $77,000. Bob’s 2021 IRA RMD is $37,118. Using the standard deduction of $28,100 (for a married couple where both are over age 65 plus a $300 charitable contribution deduction), their taxable income is $116,468. Federal taxes are $16,560.

Bill and Betty could recognize another $65,000 of ordinary income from his IRA before they land in the 24% tax bracket. In 2022, Betty will have to start taking RMDs on her IRA—did we mention that her IRA is worth $1.5 million?—which will bump them into the 24% tax bracket. Bill should take another $64,000 from his IRA, filing up the 22% ordinary income bracket and reducing his RMD for 2022.

Another example: Alan Smithers is 81 and remarried ten years after his first wife passed. His IRA is worth $1.3 million, and his daughter is the beneficiary. His IRA RMD is $66,000 and he intends to be generous with charity this year, using about $30,000 for a Qualified Charitable Distribution (QCS). Based on a projection of his 2021 tax return, Alan could take another $22,000 from his IRA, taxable at 12%. His daughter Daphne is 51, has a high income and significant assets. He should consider filling up his own 12% marginal ordinary income bracket, because when Daphne starts taking her own beneficiary distributions, she’ll be facing high taxes.

Here’s what you need to consider when making RMD decisions:

Your tax bracket. How much more income can you realize while staying within your current tax bracket? Taxpayers in the 10-12% brackets should be extra careful of maxing out on ordinary income.

Your income. What does 2022 look like for your income? Will there be other sources of income, such as an inherited IRA, spouse’s IRA RMD, or annuity income to be considered?

Beneficiaries. How does your own tax rate compare with the tax rates of your beneficiaries? If you have a large IRA and your children have high incomes, could an inheritance push them into a higher tax bracket?

Medicare Premiums. Increases in income can lead to higher Medicare Part B and D premiums in coming years, so also keep that in mind.

It’s best to take the broader view when planning for RMDs and taxes. A short-sighted approach could end up being more costly for you and your heirs.

Reference: Kiplinger (Nov. 23, 2021) “Should You Take an Extra Big RMD This Year?”

What Qualifies as a Qualified Charitable Distribution?

“Qualified Charitable Distributions, which allow Individual Retirement Account holders in their 70s and older to divert some of their federally taxable required distributions to charity while reducing their federally taxable income, are back after a 2020 hiatus.”

Qualified charitable distributions allow individual retirement holders to divert some of their federally taxable required distributions to charity, reports a recent article “A tax break for retirees is back. Here’s how to use it–and what to avoid,” from The Washington Post. Known as QCDs, they were not a big deal until 2017, when a change in the tax law changed the number of people itemizing deductions, including charitable contributions, from 31 percent to 11 percent, according to the IRS.

Tax laws let you put tax-deductible money into “defined contribution” accounts, including IRAs, 401(k)s and 403(b)s, until you reach age 72, when you are required to start taking withdrawals—federally taxable Required Minimum Distributions–from the accounts.

The size of the distribution depends upon the year-end retirement account balances and your age. If you had $100,000 in a retirement account last December 31 and turned 75 this year, the RMD is about $4,370. For an 80-year-old, the number would be around $5,350, and at 85, it would be $6,760.

In 2020, QCDs were of little interest because the CARES Act cancelled any RMD requirements. You could still use a QCD, but there was no tax advantage of reducing taxable income by offsetting required distributions.

In 2021, RMDs are back, and QCDs are worth doing again. To make a QCD, you ask the IRA administrator to send a check made out to a registered charity. You are permitted to donate as much as $100,000 per year. Let’s reinforce the message: the check must be made out to the charity, not to you. You also may not send the money to your own donor-advised fund.

IRAs can be used for QCDs, but not 401(k)s or 403(b)s.

You will need to keep track of the QCDs yourself. Do not expect the IRA custodian to do that for you. The retirement plan does send a tax form, the 1099-Rs, to the IRS that shows your total distributions for the year. The QCDs are subtracted from your 1099-R income by you or your tax preparer.

It sounds great, but there is a problem, created by the SECURE Act of 2019. That law let people aged 70½ and older make tax-deductible contributions to their IRAs. However, if you make a tax-deductible contribution to your IRA that you use for a QCD, it triggers a reduction in the amount of the QCD that you can deduct from your federally taxable income.

Do not make QCDs from the same IRA to which you are making tax-deductible contributions. You can set up a solo 401(k) if you are self-employed or use a SEP-IRA to make deductible contributions.  Here again, trouble lurks; do not make a QCD from a SEP-IRA in the same year you are claiming an income tax deduction for contributing to the SEP-IRA.

Reference: The Washington Post (March 18, 2021) “A tax break for retirees is back. Here’s how to use it–and what to avoid”

Stretch Out IRA Distributions, Even Without ‘Stretch’ IRA

                                                        

“The SECURE Act killed the stretch IRA but instead of mourning, advisors can help clients make up the loss.”

It’s sad but true: the SECURE Act took away the long lifetime stretch that so many IRA heirs enjoyed. It was a great efficiency tool for family wealth transfer, but there are ways to fill the gap. A recent article “3 Strategies That Dry Your Stretch IRA Tears” from InsuranceNewsNet.com explains what to do now that IRAs need to be cashed out within ten years of the original owner’s death.

There are a number of tax-efficient planning opportunities, falling into three basic categories: wealth replacement with life insurance, Roth planning and charitable opportunities.

The life insurance policy is straightforward: parents buy life insurance to close the gap between what the IRA could have been, if it had been stretched out over the heir’s lifetime. For parents who are in a lower tax bracket than their children, it might make sense for parents to take distributions out of their IRA and buy insurance with after-tax dollars. This method may also present an opportunity for parents to purchase life insurance with long-term care protection, if they have not already done so.

The “Slow Roth” strategy is for families who might not think they can benefit from a Roth, but they can—just not all at once. By converting an IRA to a Roth IRA over time, only in amounts that keep parents in the same tax bracket, and paying taxes on the conversion slowly and over time, the Roth IRA can be built up so when it is inherited, even though it has to be taken out within ten years after your death, it is income tax free.

The third strategy is for families already planning on making charitable gifts. A Qualified Charitable Distribution, or QDC, lets the owner make distributions directly from their IRA to qualified charities, up to $100,000 annually. Remember that the distribution must go directly to the charity and it cannot be used for a donation to a donor-advised fund or private foundation. Your estate planning attorney will be able to help determine if your charity of choice qualifies.

Finally, you can name a Charitable Remainder Trust as an IRA Beneficiary. This is not a do-it-yourself project and mistakes can be costly. By naming a CRT as a beneficiary of your IRA, you avoid taxes on the entire lump sum when the trust liquidates the IRA. At the same time, the income beneficiary of the trust can receive income from the CRT over their lifetime or a term that you determine. It can’t be more than twenty years from the date of death, but twenty years is a long time. The payments from the trust will be treated as taxable income, so be sure that this will work for the recipient. If you accidentally push them into a higher tax bracket, they may not be quite as grateful as you wanted.

Reference: InsuranceNewsNet.com (Oct. 28, 2020) “3 Strategies That Dry Your Stretch IRA Tears”

How to Lower Your Medicare Premiums

“This fall, older savers who are feeling generous may want to consider using their individual retirement account to help fund their favorite charities.”

Here’s a generous incentive for older Americans who want to help their favorite charities: by giving generously from the right asset source, they could manage their Medicare premiums for 2022. The details come from the article “Feeling altruistic? This tax strategy can keep Medicare premiums in check” from CNBC.

People who are age 70½ and over are allowed to make qualified charitable distributions from their IRAs. The IRA owner directs the custodian holding the account to transfer up to $100,000 directly to a charity. The transaction must be a direct transfer, and donor-advised funds or private foundations are not eligible for this strategy.

This is a staple of year-end tax planning for many, hitting two targets at once: older savers meet their required minimum distributions without a tax hit and their favorite causes get support. This year, there is no RMD, as a result of the CARES Act, the coronavirus relief measure that went into effect in the spring. However, a qualified charitable distribution still makes sense for people who were planning on making large donations.

Keeping a lid on Medicare premiums for 2022 Medicare Part B (Medical Insurance) and Part D (Prescription Coverage) itself is worth consideration.

Giving via a Qualified Charitable Distribution will not inflate the Modified Adjusted Gross Income (MAGI) for that year, and you also won’t pay taxes on the distribution. Remember, Medicare premiums are based on the MAGI from two (2) previous years.

It’s great to support nonprofit agencies that have meaning to you. However, doing it without taking advantage of tax planning is a lost opportunity.

In 2020, single taxpayers with a 2018 MAGI up to $87,000 (or $174,000 for married and filing jointly) pay $144.60 a month for Medicare Part B. Premiums increase depending on your MAGI, all the way up to $491.60 per month for individual taxpayers with a 2018 MAGI of $500,000 or more.

This is something to work on with your estate planning attorney, as going just one dollar over your income bracket could raise your premiums by thousands. Your estate planning attorney will be able to guide you through the various brackets, which must consider any other sources of taxable income.

Charitable giving is a great tool to shave tax liability, while doing good. Donations of appreciated stock are another strategy. Just remember that for this type of giving, you’ll need to be itemizing deductions on the return, if you want to write them off. With the standard deduction so high, it may be hard to meet that hurdle.

Reference: CNBC (Oct. 23, 2020) “Feeling altruistic? This tax strategy can keep Medicare premiums in check”

Social Security and Medicare and the Impact on Retiree Taxes

“Medicare has a series of income limits that trigger increasingly higher payments for retirees. And it’s not just the rich who are affected.”

A 70% increase in Medicare premiums to $559 was a complete surprise to a woman who became a single taxpayer when her husband died. She felt like she was being punished for being a widow, she said in a recent article titled “Retirees, Beware These Tax Torpedoes” from Barron’s. With a 2018 modified adjusted gross income of $163,414, a combination of required minimum distributions, Social Security and her husband’s pensions, she went from being in the third-highest Medicare bracket into the second highest Medicare bracket. All it took was $414 dollars to exceed the $163,000 limit.

This is not the only tax trap awaiting unwary retirees. Lower- and middle-income taxpayers get hit by what’s commonly referred to as “tax torpedoes,” as rising income during retirement triggers new taxes. That includes Social Security income, which is taxed after reaching a certain limit. The resulting marginal tax rate—as high as 40.8%—is made worse by a Medicare surtax of 0.9% on couples with taxable income exceeding $250,000. Capital gains taxes also increase, as income rises.

It may be too late to make changes for this tax-filing year, even with a three-month extension to July 15. However, there are a few steps that retirees can take to avoid or minimize these taxes for next year. The simplest one: delay spending from one year to the next and be extra careful about taking funds from after-tax accounts.

What hurts most is if you’re on the borderline of a bracket. Just one wrong move, like selling a stock or taking a distribution, puts you into the next bracket. You need to plan carefully.

One thing that won’t be a concern for 2020 taxes: required minimum distributions. While many retirees get pushed into tax traps because of taking large RMDs, the emergency legislation passed in response to the coronavirus crisis (the CARES Act) eliminated RMDs for this year.

However, the RMDs will be back in 2021, so now is a good time to start thinking about how to avoid any of the typical tax torpedoes. RMDs used to start at age 70½; the SECURE Act changed that to 72.

If you don’t need the money from an RMD in 2021, one workaround is to take it as a qualified charitable distribution. That avoids triggering higher taxes or higher future Medicare premiums. The administrator of the tax-deferred account needs to be instructed to make a donation directly to a charity.

An even better strategy: take steps long before Medicare income limits or tax torpedoes hit. If you can, live on after-tax savings, Roth IRA accounts or inherited money. Spend that money first, before tapping into tax-deferred accounts. You can then take advantage of being in a lower tax bracket to convert money from tax-deferred money to convert to Roth IRAs.

Another story of a tax hit that was avoided: a man with an income of about $80,000 prepared to take $4,000 from a tax-deferred account for a vacation. The couple’s normal top tax bracket was 12%, but they hit the income limit on Social Security taxes. The $4,000 in additional income would have caused $3,400 in Social Security income to be taxed, making his marginal tax rate 22.2% instead of 12%. With the help of a good advisor, the couple instead took $3,000 from a Roth IRA and sold a stock position for $1,000, where there were practically no capital gains generated.

Incomes at all levels can be hit by these tax and Medicare torpedoes. A skilled advisor can help protect your retirement and Social Security funds.

Reference: Barron’s (July 6, 2020) “Retirees, Beware These Tax Torpedoes”

 

 

Are You Making the Most of the SECURE and CARES Acts?

“There have been several law changes that affect IRAs passed since December 2019.”

The SECURE Act made a number of changes to IRAs, effective January 1, 2020. It was followed by the CARES Act, effective March 27, 2020, which brought even more changes. A recent article from the Milwaukee Business Journal, titled “IRA planning tips for changes associated with the SECURE and CARES acts,” explains what account owners need to know.

Setting Every Community Up for Retirement (SECURE) Act

The age when you have to take your RMD increased from 70½ to 72, if you turned 70½ on or before December 31, 2019. Younger than 70½ before 2020? You still must take your RMDs. But, if you can, consider deferring any distributions from your RMD, until you must. This gives your IRA a chance to rebound, rather than locking in any losses from the current market.

Beneficiary rules changed. The “stretch” feature of the IRA was eliminated. Any non-spousal beneficiary of an IRA owner who dies after Dec. 31, 2019, must take the entire amount of the IRA within 10 years after the date of death. The exceptions are those who fall into the “Eligible Designated Beneficiary” category. That includes the surviving spouse, a child under age 18, a disabled or chronically ill beneficiary, or a beneficiary who is not more than ten years younger than the IRA owner. The Eligible Designated Beneficiary can take distributions over their life expectancy, starting in the year after the death of the IRA holder. If your estate plan intended any IRA to be paid to a trust, the trust may include a “conduit IRA” provision. This may not work under the new rules. Talk with your estate planning attorney.

IRA contributions can be made at any age, as long as there is earned income. If you have earned income and are 70 or 71, consider continuing to contribute to a Roth IRA. These assets grow tax free and qualified withdrawals are also tax free. If you plan on making Qualified Charitable Distributions (QCD), you’ll be able to use that contribution (up to $100,000 per year) from the IRA to offset any RMDs for the year and not be treated as a taxable distribution.

Coronavirus Aid, Relief and Economic Security (CARES) Act

The deadline for contributions for traditional or Roth IRAs this year is July 15, 2020. The 2019 limit is $6,000 if you are younger than 50 and $7,000 if you are 50 and older.

RMDs have been waived for 2020. This applies to life expectancy payments. It may be possible to “undo” an RMD, if it meets these qualifications:

• The RMD must have been taken between February 1—May 15 and must be recontributed or rolled over prior to July 15.
• RMDs taken in January or after May 15 are not eligible.
• Only one rollover per person is permitted within the last 12 months.
• Life expectancy payments may not be rolled over.

Individuals impacted by coronavirus may be permitted to take out $100,000 from an IRA with no penalties. They are eligible if they have:

• Been diagnosed with SARS-Cov-2 or COVID-19
• A spouse or dependent has been diagnosed
• Have experienced adverse consequences as a result of being quarantined, furloughed or laid off or having work hours reduced due to the virus, are unable to work because of a lack of child care, closed or reduced hours of a business owned or operated by the individual or due to other factors, as determined by the Secretary of the Treasury.
• Note that these distributions are still taxable, but the income taxes can be spread ratably over a three-year period and are not subject to the 10% early distribution penalty.

Keep careful records, as it is not yet known how any of these distributions/redistributions will be accounted for through tax reporting.

Reference: Milwaukee Business Journal (June 1, 2020) “IRA planning tips for changes associated with the SECURE and CARES acts”