The 2023 holiday season has come and gone and hopefully by now, the decorations are taken down and stored, the outdoor lights are removed from their perilous perches, on bushes, gutters, and window frames, and the long since dried out real tree (assuming it’s not artificial) has been safely disposed. It’s February and the holiday season is fast becoming a pleasant memory to be replaced by a much less festive season: tax preparation season.
These days, trips to the mailbox and notifications in email inboxes are increasingly filled with envelopes and email subject lines seemingly shouting, “IMPORTANT TAX DOCUMENT Do Not Dispose.” In every case, this is good advice as it’s a best practice to over-communicate any tax-related documents to a CPA or tax preparer. One of the most important types of tax documents is the 1099-R, the form sent by the custodian to the taxpayer and the IRS. Officially, this form shows the amount and type of distributions from pensions, annuities, retirement or profit-sharing plans, IRAs, insurance contracts, etc. for the prior tax year. Not only does the form show amounts and types of distributions but also tax withholding at federal state and local levels (if applicable) and other pertinent information.
For many retirees, this form of income can amount to their largest component of taxable income, and, for some with large IRAs, it can dwarf capital gains income, social security, or other investment income. And of course, what accompanies a large distribution amount is a potentially large tax liability – sometimes retirees’ largest expense each year!
For this reason, we think it’s worth analyzing the cadence of these current and future distributions well before reaching the minimum distribution age, which depends on birth year and should be confirmed with your advisor. (Note: RMDs on a 401(k) plan, if still employed at the company with the plan, are an exception to the rule).
The Default (and most common) Distribution Strategy in Retirement (before RMDs)
The most common approach and rule-of-thumb ordering of distributions in retirement but before RMD age is to delay the tax liabilities as far out as possible and assuming non-retirement assets are available, spend those down first and do not take any distributions from the IRA until required. That has merit and can make sense in many cases. But in some unique circumstances where RMDs have not started, future RMDs will likely be very large, and a taxpayer can confidently project other forms of income and expertly project the liability, it might be very profitable to consider rethinking the default ordering strategy and analyze a more surgical strategy.
Rethinking the Distribution Strategy in Retirement (before RMDs)
In what might be considered tax planning blasphemy, it may make sense to consider voluntarily taking distributions from IRAs, even if taxable assets are available and RMDs aren’t required from the IRA yet. Why? Much like the theory around voluntarily incurring income from a taxable IRA for Roth conversions, which can allow for long-term tax-free portfolio growth (prior to RMDs), a precise and well thought out distribution strategy that includes some level of voluntary distributions from the taxable IRA might make sense for two reasons. First is a short-term event and second is a longer-term strategy.
- The Short-Term Rationale: The first reason to consider making these calculations for 2024 and 2025 is the potential for the sunsetting of the Tax Cuts and Jobs Act (TCJA) of 2017. If there is no change to the law, which is always difficult to predict, the current tax brackets will expire and revert to the rates they were prior to this law. When the law was passed, the 28% federal bracket dropped to 24%, the 25% bracket fell to 22%, and the 15% bracket fell to 12%. By closely calculating and controlling taxable income through voluntary distributions at the rates under current law, for at least 2024 and 2025, a taxpayer could, in theory, save the “spread” on these rates at the same level of income before rates spring back for tax year 2026 and beyond.
- The Long Term Play: Even with a resumption of higher rates post-2026, this strategy can still make sense over a much longer time horizon. The reason is very similar to the expiration of the TCJA of 2017, namely “tax rate arbitrage,” which is a fancy way to say paying a tax rate today in exchange for not paying a higher rate in later years. Taxpayers are effectively executing the tradeoff of keeping income with some confidence they’ll remain in the same bracket (i.e. the federal 22% which for 2024 is between $94,300 and $201,050) throughout retirement (assuming the brackets get adjusted for inflation) instead of paying little to no tax early on then rapidly accelerating to higher tax brackets for decades down the road.
And to take it even further, in some scenarios, the net benefit of a higher net wealth might come in the form of growth in taxable (non-retirement accounts) because they haven’t been withdrawn from as aggressively early on in retirement. Even if there is potential for the disadvantage of higher absolute tax dollars, this disadvantage can be outweighed by the higher growth in the other, lower taxed accounts.
Bottom Line
Staying vigilant on tax law changes and executing on these strategies requires a very specialized knowledge base, and we always recommend taxpayers work with their wealth advisor and their CPA or tax preparer to ensure accuracy. Keep in mind that voluntarily incurring income through distributions can have “collateral” damage to the overall tax liability in the form of higher social security tax, higher Medicare premiums (IRMAA), potentially lower itemized deductions, and higher capital gains taxes. So, executing these tactics should NOT be taken lightly or done without expert assistance. For some retirees with large IRAs and professional help, these strategies are, at a minimum, worth exploring. Federal and state income taxes can rapidly become the largest expense for retirees every year. Managing taxes effectively can give retirees more confidence in the sustainability and consistency of their retirement cash flow over what is usually a multi-decade retirement timeframe.