Many Wyoming workers take advantage of employer retirement plans, like 401ks or 457s, which offer tax-deferred contributions as well as matching contributions from the employer. This is an incredible benefit that should seldom be passed up. Even when you don’t have access to a 401(k), IRAs are also available to help lower your taxes and get tax-deferred growth.

A problem comes, however, when an account holder reaches the age to begin Required Minimum Distributions, or RMDs. These are amounts of money that MUST be taken from the retirement account, and taxes paid on the withdrawal.

In today’s article, we’ll discuss how the RMD is really a tax “BOMB!” for retirees, often adding thousands of additional dollars to their lifetime tax bill! Are there some ways to prevent this? Read on!

Tax Breaks and Tax-Deferred Growth: What’s Not to Like?

By making 401(k) or IRA contributions, you immediately receive a reduction in your taxes. These are real dollars, and it feels great to lower your taxes. Further, as your retirement investments grow over decades, there is no ongoing tax. That’s a big savings!

Except it’s not really a savings at all, it’s a deferral, meaning, you’re gonna pay later. The time to pay is whenever you start taking withdrawals from your account, which can be as early as age 59 ½. Even if you don’t withdraw funds at this age, you’ll still face RMDs between ages 73 to 75.

This is where the tax bomb comes in.

The IRA Tax Bomb

The IRS uses a formula to calculate your RMD. Generally, it starts at around 4% of your prior years’ IRA balance and increases as you age.

Example: Bill has reached age 73 and is subject to an RMD this year. He and his wife live comfortably, collecting Social Security of $40,000, a Wyoming Retirement System pension of $40,000, along with his wife’s Social Security of $20,000. He has a Rollover IRA balance of $1,000,000. Bill’s RMD this year will be $40,000, and he must take it even if he doesn’t need the funds.

Think about this. Bill’s retirement income needs are met through his and his wife’s Social Security and a WRS pension. If he could leave the funds in his IRA, he would do so, but he’s not allowed. This not only creates additional taxes for Bill and his wife, but the forced withdrawal also results in increased taxes on his Social Security payment, since Social Security taxes are based on your total income.

Furthermore, even if Bill never had to take an RMD from his IRA, the tax bomb follows him. If Bill left this large IRA to his three children equally, each of them would inherit $333,333 and have just ten years to fully deplete the IRA, owing taxes on the withdrawals! The tax bomb followed his kids beyond the grave!

Potential Tax Bomb Workarounds

Is there any way to reduce or even fully avoid this tax hit? Fortunately there are, but it takes some savvy, long-term thinking.

Workaround #1 - Roth Conversions

Roth conversions are one path. I wrote about these recently, and you can get the rundown using this link. Roth conversions are a great way to reduce the balance of your IRA, and thus reduce the amount of your RMDs. Plus, Roth IRA investments grow tax-free, come out tax-free, and are passed on to heirs tax-free, with a 10-year required draw down period (also tax-free).

There’s a slight wrinkle, however, in that RMDs cannot be Roth converted. This further underscores the tax bomb’s “ticking clock” as the RMD timeline approaches.

Let’s go back to an earlier time of BIll’s life to illustrate.

Example: Bill retires at the age of 65, starts collecting his WRS pension, and delays his Social Security until age 70. He doesn’t reach his RMD age until 73. This gives Bill about 8 years to prepare himself for the IRA tax hit due to his RMDs. In working with his financial advisor and tax preparer, Bill discovers that he and his wife are in the 12% federal marginal income tax rate, which historically is quite low, and owes no state income tax in Wyoming. Over the next 8 years Bill converts an average of $40,000 per year to his Roth IRA, resulting in $320,000 in his Roth IRA by the time his RMDs begin.

Notice that Bill has still faced a tax bill, but since he delayed his Social Security for the first 5 years, he was able to convert a considerable portion of his IRA to a Roth IRA at lower tax rates. This reduces his IRA balance to $680,000, and his first RMD is now $27,000 versus $40,000.

As an added bonus, Bill doesn’t have to wait until his retirement to convert IRA funds to a Roth IRA. He can do this anytime, but once those RMDs begin, the conversion opportunity shrinks drastically.

The biggest win here is that Bill and his wife now have a $320,000 Roth IRA that will continue to grow tax-free, withdrawals are tax-free, and his heirs have tax-free withdrawals also.

Workaround #2 - Qualified Charitable Distributions

Utilizing Qualified Charitable Distributions, or QCDs, is another path. QCDs are gifts made from your IRA to a nonprofit organization. Instead of taking the money yourself, it’s sent directly to a charity with no tax consequences at all, and it still fulfills your RMD requirement.

Example: Bill and his wife realize that their retirement income needs are well-met with their Social Security and pension income, and they have followed the Roth conversion strategy illustrated earlier. They are charity-minded, so they decide to give a large QCD of $27,000 RMD to their church, local food bank, and local animal shelter ($9,000 to each). They will owe no taxes on these gifts, their RMD for the year is fully satisfied, and their Social Security tax won’t be increased.

Again, notice that Bill’s QCD has completely fulfilled his RMD requirement, and he can continue to do this each year for as long as he’d like.

We hope this article has been helpful. IRAs are a wonderful retirement savings tool, but the tax man cometh, and RMDs will be a large unexpected “gotcha” for many retirees. It’s very much worth exploring ways to reduce the RMD burden by utilizing Roth conversions or Qualified Charitable Distributions. Don’t wait until retirement comes to do some planning. The lifetime tax savings can be substantial!