How to Avoid IRA Distribution Risks

While many Americans delay taking their IRA distributions, this can lead to unexpected pitfalls. Many retirees fall into tax traps created by delaying IRA distributions. At REAP Financial, we guide our clients to get the most out of their retirement by planning accordingly. Today, we’ll walk you through why you may not want to delay taking your distributions and the strategies you can follow to get control of your taxes in retirement.

Myth Busted: Lower Taxes in Retirement

Many retirees fall into tax traps created by delaying their IRA distributions. Delaying IRA distributions can feel like the right choice, since it delays the tax payments and allows us to keep more money in our IRAs. However, this can lead many retirees to inadvertently set themselves to be taxed on much larger amounts later. 

When you put money in an IRA, you get a tax deduction. For many people, they’ll put $7,000 – $8,000 every year into the account during their working years. As you put money into the account, you receive tax deductions. But, once you’re retired, those funds will be taxed as income. Ultimately, the IRS will be in charge of how high the tax will be, and we don’t have any direct visibility to that now, since tax rates change over time. 

Most Americans carry the bulk of their wealth in IRA accounts, allowing that money to grow. Once they hit retirement, account holders begin to leverage that money to pay their expenses. That leads to our key question: should you take out IRA dollars early in retirement, spread them out over time, or delay touching the money until the age of minimum required distributions. While everyone’s situation is different, we find that for retirees who have saved two million dollars or more face large required minimum distributions. These distributions are often so high that they bump retirees into higher tax brackets, since it counts as income. Since those required minimum distributions commonly occur yearly, even if it doesn’t push retirees into a higher tax bracket in the first year of distributions, it likely will at some point in the future. 

As we’ve discussed before, the required minimum distributions (RMDs) can have a wide impact on your finances, from your tax bracket to Social Security and Medicare premium costs. This may be even more impactful in the future, if the government decides to vary Social Security based on individual’s means. We have reason to believe Social Security benefits will be means-tested in this way in the future, since the same principle already applies to Medicare: the more you make, the higher premiums you pay for the same care. For these reasons, managing your IRA distributions is very important, since it allows you to have more control down the road. 

Need-to-Knows: Required Minimum Distributions

One more thing to consider is what your RMDs will look like. RMDs are based on how much pre-tax money you have, as an individual. All of your pre-tax retirement accounts are aggregated and used to determine your RMDs, based on how much money was in the accounts at the end of the previous year. The first year’s RMD starts at about 3.65% of the aggregate balance and goes up every year from there based on your life expectancy. We won’t cover that today, but it boils down to one takeaway: by taking your distributions early in retirement, you are potentially reducing the amount your future RMDs will be. 

Delaying distributions may also have impacts on your heirs, who could inherit more in pre-tax accounts. A lot of people want to leave money to their heirs, but IRAs are not always the most effective way to do it. After the Secure 2.0 Act passed, your heirs are now required to withdraw all money inherited in pre-tax accounts over a 10 year period. If you plan to leave money to your heirs, it could make sense for you to accelerate your distributions from an IRA, so you can pass on money through brokerage accounts, money markets, CDs, and the like, which could potentially be left to them tax-free. 

Finally, we consider the ultimate accounts: the Roth 401k and Roth IRA. Under today’s law, those accounts don’t have RMDs. Those accounts give you more control, even passing on money to your heirs tax free. Under today’s laws, you will never be forced to take money out of these accounts, allowing you to create more value through a snowball effect. 

Customizing Your Distribution Strategy

That leaves the question: should you distribute out of the IRAs in early retirement or should you defer until the RMDs kick in? At REAP Financial, we consult families year-round who are concerned about increased taxes or changes to the Social Security benefits in the future. In some cases, families won’t have any issues with these concerns, based on their portfolio and how it’s structured. However, in other cases, many families don’t even realize that they’re going to be facing these issues in the future. For those clients, we arrange their portfolios in a way that gives them greater control. It all comes down to strategizing correctly. 

The strategy hinges on two main points: if you’re a candidate (or not) to take distributions early in retirement and how much money you should convert to a Roth IRA. Very few people should convert everything to a Roth IRA, but many will want to to some extent, since it reduces your future required distribution. There is a sweet spot for everyone, which balances how much you should convert over your lifetime and over how many years that conversion should take place. In many cases, clients want to address the heavy-lifting of the conversion before reaching their RMD age. 

If you’re in your early 60’s and considering this, you have plenty of time to do this conversion. This is great, since the more time you have, the smaller the cost will be to get your assets into the Roth. The trick is figuring out when you should begin converting and how much you should be converting to find your sweet spot, where you have maximum control over your taxes in retirement. 

How to Get Your Tax Savings Analysis

This is part of our day-to-day work at REAP Financial, as we are passionate about helping our clients maximize their retirement and legacy. We can even run a 60-minute tax savings analysis for you, virtually or in-office in Austin, Texas. In that 60 minute session, we identify whether or not you are a candidate to take Social Security early, take your IRA distributions early, and how much you should convert to a Roth IRA. If this interests you, we implore you to take advantage of this 60-minute session with our expert fiduciary advisors. Email us at retire@reapfinancial.com to request your tax savings analysis now, and we’ll reach out to schedule your appointment! Your future self will be glad you did! Contact us today for a consultation, and begin your journey toward a serene retirement in Austin.

Phone: (512) 249-7300

Our Main Office Address

REAP Financial

9414 Anderson Mill Rd #100

Austin, TX 78729

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