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Posts Tagged ‘RMD’

Get $100,000 Tax-Free Annually in Retirement

Some tax strategies are so common most people know about them. Why is it then almost nobody is using the strategy?

A large part of my tax practice is consulting. There isn’t much room for more tax preparation clients. However, I love helping people reduce their taxes, so I spend considerable time outside tax season working with good people designing strategies tailored to their personal needs.

The past several months I have repeated the tax break in question countless times. It is missed nearly 100% of the time. Of my regular tax clients, the ones using this strategy did so at my encouragement. 

It started earlier this year when I published this post on traditional retirement accounts and how they have an implied interest rate on the tax savings. Before that I published this post because I was seeing consulting clients who had rather large retirement accounts at a young age.

It is to be expected in a community of savers and investors to have large retirement accounts at an early age. My lament was about how big those accounts were going to get and the loss of control over tax issues in the future as a result. 

When the accountant loses control over managing your taxes it means you pay more. This might not seem like a such a big deal because these people have a large amount of liquid investments, much of it in traditional retirement accounts, and can afford to pay more in taxes. But people don’t stop by this place to hear they need to pay more. 

Folks around the FI (financial independence) and FIRE (financial independence/retire early) communities tend to max out tax deductions up front so they can build their net worth faster. I cautioned against this knee-jerk reaction.

Most people in these communities would be hard pressed to give the appropriate amount to invest in a Roth versus a traditional retirement account for their optimum tax advantage over their lifetime. At Camp Accountant I discussed the issue further.

The more I thought about the issue of large traditional retirement account balances the more I realized this was not just a wealthy person issue. There is a tax strategy with the ability to make a real difference for people even in lower tax brackets, in fact, any tax bracket.

 

RMD

The problem is the required minimum distribution (RMD). Before the RMD kicks in at 70 1/2 you retain control over your tax situation by making choices best for you. In the earlier posts I outlined how some people with modest traditional retirement account balances would see very large balances after another 30 years of growth. I illustrated an example of a client facing $500,000 in RMDs down the road. There isn’t much tax planning you can do after that.

Of course, many readers felt this was not a real world issue. It is, but not for many. 

Charitable giving, like this animal shelter, has never paid so well. Make a difference that really counts.

The problem with the RMD is loss of control. Once you reach 70 1/2 you have until April 1st of the following year to distribute a certain amount from your traditional retirement accounts. If you wait until the following year you need to take out double that year. Therefore, for most, it is best to start taking the RMD the year you reach 70 1/2.

The RMD is required every year you have a traditional retirement account once you reach 70 1/2. The Secure Act working its way through Congress could delay the RMD until age 72, but that has not yet happened. If you are still working you can delay the RMD for money in the 401(k) where you work, with some restrictions.

The RMD can do serious tax damage. For example, if your only income is Social Security and an RMD from your retirement account of $40,000, some of your Social Security benefits will be taxed. Worse, you could pay more for Medicare coverage the following year.

By age 70 you are probably not itemizing. The house is paid off so all that remains is state and local taxes (SALT), which are capped at $10,000 per return, and charitable contributions. Yes, if you have really high out of pocket health insurance and medical expenses you might get a deduction there, but it is really hard to get the deduction as the first 10% of adjusted gross income (AGI) needs to be exceeded before you can claim any of the healthcare expense.

If you donate large amounts to charity there is another problem. The RMD increases your taxes and could turn some of your Social Security benefits taxable as well. Then you need to exceed the standard deduction ($24,400 for joint returns/$12,200 for singles for 2019) before any of the charitable deduction counts.

And that is where out tax strategy shows up.

 

The Gift that Keeps on Giving

Under current tax law you can give to charity directly from your traditional retirement account (tIRA, SEP and SIMPLE, including inactive SEP and SIMPLE plans that no longer receive contributions), up to $100,000 per year, per person, once you reach age 70 1/2. If you are not this old yet you certainly have friends, family and neighbors who are and they need to hear about this.

Money sent directly to a charity from your traditional retirement account is excluded from income up to the $100,000 limit!

For this to work the retirement plan administrator must send the money directly to the charity. You will still get a 1099-R at the end of the year. Nothing on the tax document tells you how much was sent directly to the charity so you must tell your tax professional the amount to get the tax break. My office tax software has a “special situations” page I go to on the 1099-R screen to enter the amount to exclude from income. 

This is important. While only a few will suffer the consequences I outlined in prior posts, many will pay at least some tax on their RMD. Many will also end up paying tax on up to 85% of their Social Security benefits and pay more in Medicare premiums than they have to.

Let me clear up a few points before continuing. You can have more than the RMD sent to the charity from your retirement account. The limit is $100,000 per person, per year, as stated above, that can be excluded from income each year, even if your RMD is lower. If you give more than the RMD, the excess will not lower the next year RMD, but is still excluded from income up to to the limit. The RMD is still required in subsequent years without regard to prior distributions in excess of the RMD in past years.

 

Considerations

There are no drawbacks from using this tax strategy. The qualified charitable distribution (QCD), as this strategy is called, is excluded from income, never reaching the front page of Form 1040. This means that your income is lower. Your Medicare premium may be lower as a result and Social Security benefits might be taxed less or not at all.

There are other issues on your tax return that might be affected as well. Your facts and circumstances will determine those additional tax savings.

There is one lifestyle change required if you are donating to your church, synagogue or other religious organization. You should make your donation via your traditional retirement account, up to $100,000, to your church. No more money in the plate on Sunday (or whichever day you have services). This means you will not be tossing an envelope in the plate at the service. It’s no big deal because the additional tax savings mean you can fund your religious organization more from the tax savings. But it might feel weird not donating to church each week when the plate is passed.

You must be 70 1/2 or older at the time of the donation, not just the year you reach 70 1/2. If you reach 70 1/2 on November 18th, then the first day you can gift with a QCD is November 18th.

Be sure the charity gives you a receipt for the donation. You will need it for your tax records should you be audited.

 

Who Can You Donate To?

This is where it gets fun. The Internal Revenue Code (IRC) allows a wide range of organizations you can donate to under a QCD, as listed under IRC Section 170(c). Here is the list in English:

  • A U.S. state, possession, the District of Columbia and the United States federal government itself. Yes, the government will give you a tax break for giving all the money to them. Just had to get that out of the way.
  • Any community chest, corporation, trust, fund or foundation (organized or created in the U.S.), operating exclusively for charitable, religious, educational, scientific, or literary purposes, or for the prevention of cruelty to children or animals. 
  • Your church, synagogue or other religious organization.
  • War veterans’ organization or its post, auxiliary, trust, or foundation organized in the United States or its possessions.
  • Nonprofit volunteer fire companies.
  • Certain civil defense organizations.
  • Domestic fraternal societies (operating under the lodge system), if the contribution is used exclusively for charitable purposes.
  • A nonprofit cemetery company in some instances.

 

Part of your legacy planning starts long before your leave this world. You can make a difference. You built wealth with hard work, frugal living and prudent investing. These skills mean you are unlikely to spend it all. By giving to worthy charities of your choice you can enjoy the fruits of your giving by seeing your donations in action.

By using the QCD tax strategy you can reduce your taxes, reduce or avoid taxes on Social Security benefits and potentially reduce your Medicare premiums. This means you will have a larger legacy for your loved ones or to fund charitable causes dear to your heart at a greater level. 

You worked hard for your money. Now you can make a bigger difference than ever. The pay-it-forward revolution starts here.

 

 

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Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

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cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

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When Adding to Your Retirement Plan is a Bad Idea

You're retired now; you're not supposed to pay taxes anymore. Simple strategies to avoid taxes on capital gains, retirement distributions and Social Security.Building a large nest egg fast requires fancy footwork involving a high savings rate and avoidance of taxes. At least that is the conventional wisdom. 

But conventional wisdom has been wrong before and even in demographics such as the FIRE* community where the idea of maxing out retirement accounts is practically a religious belief, cracks are beginning to appear.

Less understood are the benefits of NOT investing in a retirement account. Yes, traditional retirements accounts (tIRA and t401(k)) reduce your taxable income while providing tax deferred growth. But when the money comes out it is all taxed at ordinary rates while a similar investment in a non-qualified account will largely have been taxed at the lower long-term capital gains (LTCG) rate, though without any tax deferral.

Other serious issues arise from fully funded retirement accounts. Once you hit age 70 1/2 you must take a distribution from traditional accounts—the dreaded required minimum distribution (RMD). RMDs reduce your ability to control your tax matters which means fewer potential tax credits, higher Medicare premiums and taxation on up to 85% of your Social Security benefits.

 

A Growing Problem

Recently I was a guest on The FI Show podcast. Cody and Justin did a great job prying solid tax information out of me. Things I think are normal problems to deal with are unheard of by the general public. Except the general public will suffer the consequences. And Cody and Justin knew a good story when they heard it. 

The one issue I brought up that shocked most was the size of the RMD some people will face and the catastrophic tax issues involved as a result. I mentioned I have a few clients looking down the barrel of a half million dollar RMD when they hit 70 1/2. This was shocking news, but it shouldn’t be.

The broad stock market averages in the U.S. (S&P 500, for example) tend to increase about 10% per year on average, or about 7% after inflation. (Stocks for the Long Run by Jeremy J. Siegel)  Depending on the time frame covered skews the averages a bit above or below the stated returns so we will use these numbers loosely for illustrative purposes only. 

5 ways to avoid taxes on required minimum distributions. Tax-free retirement income. Why a non-retirement account can be better than a retirement plan.This means if you invest $1,000 today in a broad-based index fund you can expect the investment to double in nominal terms in around 7 years and in real terms every 10 years. 

Here is where the problems begin. A common question from clients is how to add even more to their retirement plans to defer taxes. If the client is in the early stages of building wealth this makes sense. But if a client is 50 with $2 million in traditional retirement plans we need to discuss the issues further before adding to the stack.

Remember, a 50 year old will need to start taking required distributions in 20 years. Since, on average, the investment will double every 7 years in nominal terms the $2 million doubles to $4 million, then to $8 million and then to nearly $16 million when RMDs kick in!

While $2 million sounds like a lot—and it is; trying to save a few more tax dollars today can hurt you a lot later. In the example above the RMD the first year exceeds $500,000! There is not a lot of tax planning I can do for you at that point to help you. It’s required! That means control of your tax situation is reduced to the point of Band-Aide solutions, if that. 

Now I understand you might be younger and have less than $2 million socked away. But the earlier you start (I’m talking to members of my FIRE community here) the bigger the numbers get. If, for example, you manage a mere $100,000 in your traditional IRAs and 401(k) by age 30 and never drop another dime into those accounts and the market just performs average you get 40 years of compounding growth, or almost 6 doublings! 

Visualize the growth. From $100,000 to $200,000 to $400,000 to $800,000 to $1.6 million to $3.2 million to almost $6 million! (Remember we get just shy of 6 doublings.) 

Six million is a smaller problem than our first example, but still an issue. And it assumes you never defer another dime into your traditional retirement accounts.

 

5 Ways to Avoid RMD Problems

Whenever I consult with a client I have to make clear my advice will consider “all years” rather than just “this year”. If my advice saves you money this year but increases your taxes the next or some future year, the benefit is less than it appears up close. 

Traditional retirement plans are just such an example where “all years” planning is so important. A few million in a traditional retirement account with generate adequate RMDs to cover a very ample lifestyle. The drawback is the increased taxes on Social Security benefits and taxes on the RMD at ordinary rates.

When adding to your retirement account can cost you taxes later. Alternatives to retirements plans. Retirement planning for tax-free living.Solution 1

After a certain point (your facts and circumstances will determine that point) it is better to fill your Roth IRA or use the Roth feature of your 401(k). Yes, the Roth gives you no up-front tax deduction. But, the earnings growth is NOT deferred; it is TAX-FREE! 

RMD issues don’t plague the Roth investment the way it does traditional plans. Roth distributions are also tax-free which add flexibility to tax planning in later years. This makes the job for a future Wealthy Accountant working with you to save you money easier. (I assume I’ll retire at some point, if only because I forget to breath one day.) 

Also where traditional retirement plans are a tax nightmare for beneficiaries when you die, the Roth is a much more pleasant experience. 

I’m perplexed when people show reluctance in filling a Roth investment. The tax deduction today in minor compared to the future taxes avoided due to the tax-free nature of Roth growth! Remember, this thing tends to double every 7 or so years. A 25 year old dropping a mere $5,000 into a Roth can expect somewhere around $500,000 at age 70! That means $495,000 tax-free dollars. I’m sorry, I can’t find you a better deal than that. (Not legally, at least.)

Solution 2

There also seems to be a fear amongst some when it comes to investing in non-qualified (non-retirement) accounts. To these people there is something sacrilegious about not getting a deduction and paying taxes as you go. And I can’t understand why.

Think of it this way. When you take money from your traditional retirement plan, the one you got a deduction for up front and enjoyed tax deferral on the gains, you pay tax at ordinary rates which currently top out at 37%. And state taxes can add more.

But your non-qualified plan also enjoys a lot of tax deferral! Index funds are by design tax efficient. This means they are not trading a lot to get incremental gains at the expense of extra taxes. This also means most index funds throw off few capital gains, hence a de facto deferral. Only dividends are currently taxed and most of these are qualified and taxed at LTCG rates. 

The highest LTCG tax rate is 20%. And many will pay 0% tax on LTCGs. (In 2019 a joint return can have income up to $78,750 before LTCG are taxed. And the 20% rate doesn’t kick in until your reach $488,851.) 

Because a lot (most) of your gains are deferred anyway with an index fund and the tax rate is lower when you do sell (compared to traditional retirement accounts) and there are no RMDs or early withdrawal penalties, non-qualified accounts should play a central role in the portfolio of most investors.

The deductible retirement account investment is not the default.

Keith’s Rule 76: If investing in a deductible retirement account doesn’t provide additional tax benefits outside a simple deduction it is probably not worth it.

This means that dropping money into a 401(k) at work needs matching to offset the future losses from higher taxes and RMD issues. It also means you need to consider if a contribution to a traditional retirement account will provide larger credits elsewhere (Education Credits, Saver’s Credit, Earned Income Credit, Premium Tax Credit, et cetera). 

It’s not always a simple calculation. An IRA deduction might not work while profit-sharing in your business might. Facts and circumstances play a vital role. 

Solution 3

Once you reach age 59 1/2 you can start taking money out of your retirement accounts without tax penalty. This makes a lot of sense if you retire early, even if you don’t need the money.

Your income level will determine if this works for you.

By the time you reach 60 you may either have retired or slowed down to part-time or accepted a less stressful, lower income profession. As a result your tax bracket might be zero or something close to it.

With the standard deduction for joint returns now $24,000, many will have ample room to move money from retirement accounts early. If your income is comprised of LTCGs only there is an opportunity to move some money from retirement accounts tax-free.

Remember, joint returns enjoy tax-free LTCGs up to $78,750 of income. If you take a $24,000 distribution from your traditional retirement account and have another $40,000 of LTCGs you would pay zero tax. The standard deduction would cover the retirement distribution and your income would not exceed $78,750 so your LTCGs would also be tax-free.

Take taxes out of retirement. You paid taxes your entire working life. It's about time you got to live without government fingers in your pocketbook.Solution 4

Some of you are hyper-savers and started maxing out retirement accounts at a young age. Now you have $1.5 million and you still haven’t reached the ripe old age of 40. Your RMD issues are going to be huge even if you stop adding to the pile now.

Your reasoning for building such a large nest egg at a young age was so you could take time to be with family and travel.  Enter Section 72(t) of the Tax Code.

Section 72(t) says you can withdraw money at any age from your traditional IRA without penalty if you follow a few rules.

  1. Distributions are based on IRS tables. The larger your account balance and the older you are the more you can access under 72(t).
  2. Once started, you must take the same distribution each year for at least five years or until you reach age 59 1/2, whichever is later. (There are some rules that allow for increasing your distribution each year based on inflation.)

Distributions under 72(t) are taxed as ordinary income without penalty. 

Warning! If you fail to continue taking the required 72(t) distribution for 5 years or until age 59 1/2, whichever come later, all prior distributions under 72(t) are subject to penalty.

Section 72(t) is a powerful tool in tax planning for early retirees. Since your income is lower you effectively get tax-free, or nearly so, distributions while also enjoying potential tax-free LTCGs.

Solution 5

Sometimes I have to pull out all the stops to protect my client. That is why I consider it vital to keep RMDs below a certain threshold if at all possible.

The reason I mentioned on The FI Show podcast a few clients I have facing $500,000+ RMDs is because I lose all control in tax planning with these clients. Which begs the questions: At what level of RMD do I retain at least some control?

Glad you asked.

The answer is: $100,000.

Here’s why.

Under current tax law I can have my client elect to have up to $100,000 of her RMD sent to a charity of her choice and not include it in income.  

This is more important than you think! The ability to not include up to $100,000 in income allows me to potentially access a large sum of LTCGs are low or no tax. It might also allow fewer Social Security benefits to be included in income. 

This strategy allows me to micromanage with the client for an optimum tax outcome. The more room I have to move, the better the magic I can perform.

 

Final Comments

Conventional wisdom is NOT always right! Filling retirement accounts to the brim make for great titles on CNBC and personal finance blogs, but around here we are more interested in workable knowledge. One size does not fit all.

Consider this one last point. A non-qualified account not only enjoys significant tax deferral and lower tax rates on LTCGs, but also opens the possibility to tax-loss and -gain harvesting. Two additional powerful tools in the wealth-builders toolbox.

Always consider your facts and circumstances. I’ve consulted with several thousand clients this past decade and it is rare that any two got exactly the same advice. It is never that easy. Never. The individual is important. You are the most important part of the equation. 

These ideas I shared with you today are only a start. They are the framework to build your financial plan. But the details require the master’s touch.

 

* Financial independence, retire early

 

 

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cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here.