How Required Minimum Distributions Affect Your Choice of IRA
Using Roth IRAs for retirement savings is often recommended by financial gurus. But do you know why a Roth might be better than a Traditional IRA?
Last week I went over some of the basics of IRAs and talked about the #1 factor to consider when choosing a Traditional or Roth IRA: Taxes.
But there’s another big reason why you might want to choose a Roth IRA over a Traditional IRA. Turns out, a Roth IRA can give you more flexibility in retirement than a Traditional IRA does. This flexibility can help you save a lot on taxes and Medicare premiums while you’re retired.
Traditional or Roth IRAs: Review of the #1 Factor
When deciding whether to put your savings into a Traditional or Roth IRA, the #1 thing you have to consider is taxes. Will your tax rate in retirement be higher, lower, or the same as it is today?
Last week I showed you how taxes affect Traditional and Roth IRAs, as you can see below.
I also included a couple of Rules of Thumb to help you with the Traditional vs. Roth IRA decision.
Tax Rate in Retirement < Tax Rate Today: Favor a Traditional IRA
Tax Rate in Retirement > Tax Rate Today: Favor a Roth IRA
Tax Rate in Retirement = Tax Rate Today: No difference; Traditional and Roth IRA will yield the same result
Resolving the “tax question” is the #1 thing you need to consider when selecting the right IRA type. You want to minimize the taxes that Uncle Sam takes out of your retirement savings. [See last week’s post for an in-depth look at how different tax rates play out.]
Now I want to show you another reason why a Roth IRA might be a better option compared to a Traditional IRA. This best applies if you expect your tax rate in retirement to be similar to what it is today (i.e. the 3rd rule of thumb). It boils down to FLEXIBILITY.
Required Minimum Distributions: Uncle Sam’s Retirement Tax “Stick”
Uncle Sam likes his taxes. In fact, he likes his taxes so much that he set up some rules to make sure he’s able to get his hands on your retirement savings while you’re alive!
One of the “sticks” the government uses to get their cut of your retirement income is something called Required Minimum Distributions, or RMDs for short.
The RMD rule says that you have to start taking money out of your Traditional IRA after turning 70-½ years old. You don’t get to choose whether to take your RMD each year or not. You HAVE to. Otherwise, the IRS will assess a 50% penalty on what you should have taken out. 50%!!
It doesn’t matter whether you need the money or not. In fact, I’ve seen cases where a senior was living comfortably on their Social Security and didn’t need money from their IRA. The IRS doesn’t care. They want to tax your Traditional IRA monies.
Even worse, the amount they force you to take out of your account increases each year until you die, as you can see here.
The required % of your portfolio the IRS forces you to take out of your IRA starts off low, at 3.6%. But this increases each year, surpassing 6% by the time you turn 83 and 10% if you make it to age 93!
Why does the RMD rule exist?
Remember, when you put money into your Traditional IRA, you got a tax benefit. It’s called a pre-tax contribution.
As you contribute to a Traditional IRA, your money grows tax-free. So no tax is paid when you contribute …and no taxes are paid while you invest and grow those funds.
When does the IRS get their cut? When you take money OUT of the IRA, as seen in the first graphic above. Every dollar you take out of your Traditional IRA is counted as Ordinary Income which you’ll have to pay Federal and State taxes on.
RMD rules force you to take money out of your Traditional IRA. But what RMD rules are really doing is forcing you to pay taxes!
Why RMD rules matter for the Traditional vs. Roth IRA debate
The most important word in “RMD” is “Required.” If you have a Traditional IRA, you are REQUIRED to follow the RMD rules and start taking money out of your IRA after you turn 70-½ years old.
Roth IRAs, on the other hand, are NOT required to follow RMD rules. The reason is simple: you already paid your tax when you put the money into the Roth IRA. That’s why they call Roth IRA contributions, “after-tax contributions.”
- Traditional IRAs: Must follow Required Minimum Distribution rules
- Roth IRAs: Not subject to RMD rules
Since Roth IRAs are not subject to RMD rules, YOU get to choose when and how much money you take out of them. The one stipulation is that you’re at least 59-½ years old, otherwise, the IRS will penalize you 10% for early withdrawals, with some exceptions.
It boils down to this: with Traditional IRAs, the IRS limits your flexibility to leave money in there if you don’t need it. With Roth IRAs, you have lots of flexibility. Traditional IRAs are subject to RMD rules. Roth IRAs are not.
This is why the scales tip in favor of a Roth IRA. If your future tax rate in retirement is expected to be similar to what your marginal tax rate is today, then the decision comes down to flexibility. And Roth IRAs give you more flexibility.
Let me remind you of something before you get carried away with the idea of Roth IRAs. If your future tax rate is expected to be LOWER than what it is today, then you’re almost always going to be better off in a Traditional IRA, regardless of the RMD rules. Flexibility is great. But paying a lower tax rate trumps flexibility.
Two More Benefits of No-RMD Roth IRAs
There are two other, smaller, benefits of having a Roth IRA in retirement. As we’ve seen, not having to take Required Minimum Distributions on your Roth IRA gives you a lot of flexibility. And not having to take RMDs can benefit you in two other ways.
First, the Medicare premiums you start paying at Age 65 depend on your income. If you have a substantial retirement nest egg in a Traditional IRA, then any money you take out is considered Income. RMDs force you to report Income whether you want to or not.
The higher your income, the higher the monthly premium you have to pay for Medicare, as seen here in this table from Medicare.gov.
Since Roth IRA withdrawals are tax-free in retirement, anything you take out of your Roth IRA will NOT count as income on your taxes. No income = no higher Medicare premiums.
Secondly, your Social Security benefits may be taxed if your income is high enough. If you’re a married couple with more than $44,000 of income, up to 85% of your Social Security benefit is subject to taxation.
Again, any money you take out of a Traditional IRA will count as income, including your Required Minimum Distribution. Withdrawals from a Roth IRA don’t count as income.
Hopefully, you’ve seen why a Roth IRA might be more attractive to you compared to a Traditional IRA. It boils down to having the flexibility to take money out of the account when you need it, not when the IRS tells you to.
A Roth IRA can also save you from paying higher Medicare premiums and taxes on your Social Security income.
While this sounds like a solid case for a Roth IRA, it’s critical that you work with someone on this kind of advanced retirement planning. A Certified Financial Planner (CFP®) will be able to help you:
- Figure out whether your tax rate in the future might be higher or lower than it is today
- Decide how to fund your IRA, particularly if you have a retirement plan available to you at work
- Create a retirement savings plan that will lead to a valuable retirement income plan
- Balance retirement against your other goals, such as saving for college or caring for an elderly parent
Your retirement SAVINGS plan needs to work towards a valuable retirement INCOME plan. This requires diligent planning. Strategies to take advantage of Roth IRA opportunities need to be planned for well in advance of retirement.
I’m here to help you create a retirement plan that’s comprehensive and well thought out. If you’re not sure how your retirement plan is going to play out until the day you die, then let’s talk. There’s no obligation to get together and discuss your concerns.
Find out what I can do for you and then decide if we should be working together!
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