In March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law, providing $2.2 trillion dollars of economic stimulus. Among the benefits in the CARES Act was the suspension of required minimum distributions (RMDs) in 2020 for individuals who are subject to RMDs either because of age (formerly age 70.5, now age 72) or by ownership of an inherited retirement account.
For individuals who depend on the funds from their required minimum distribution each year to fund regular living expenses, this one-year RMD suspension is effectively a non-event. Such individuals will distribute funds from retirement accounts in 2020 not because they are legally required to do so but to fund consumption and pay the bills. Conversely, this one-year suspension provides a nice reprieve for individuals who would normally be subject to RMDs but have funds available from other sources (pension income, after-tax investment and bank accounts, Social Security, etc.) to afford regular living expenses without the RMD funds.
Many individuals who fall in this second category will take the easy route and simply forego the 2020 RMD based on the short-sighted fallacy that to do so is advantageous. While this easy “do-nothing” route will almost always yield lower taxes in 2020, it will typically result in higher long-term taxes for most individuals who fail to exploit the one-year opportunity.
Astute individuals who are annually required to withdraw retirement funds that they do not need will appreciate that the 2020 reprieve from RMDs provides an attractive opportunity for long-term tax planning – an opportunity that will expire at midnight on December 31. Consider the following example:
Example 1: David and Carol turned 73 years old in 2020. They each collect Social Security that pays a combined $36,000 per year and Carol has a pension that pays $40,000 each year. They also have two investment accounts – David’s IRA with $1,500,000 and a joint brokerage account with $1,000,000 that together provide for the remainder of their retirement spending. In light of cancelled travel plans due to Covid-19 and limited expenses for dining out or other discretionary expenses, their spending needs in 2020 are relatively modest and they only require an additional $1,000 per month (12,000/year) beyond what Social Security and Carol’s pension provides. They have no mortgage, expect to use the standard deduction every year, and were able to harvest taxable losses during the March market selloff such that they will have $3,000 of capital losses to offset other taxable income.
The simplest strategy would be for David and Carol to use the joint brokerage account to fund the $1,000/month of additional spending needs and move onward to 2021 when David will again face required distributions from his IRA. In doing so, their federal tax situation looks as follows:
The good news under this scenario: David and Carol owe $6,070 in federal income taxes, a significant break from what they typically owe when faced with a required distribution from David’s IRA. The bad news: they squandered the chance to exploit their significantly lower 2020 tax bracket.
When the RMD suspension is lifted in 2021, David will face a required minimum distribution of approximately $60,000 from his IRA, resulting in total taxable income for the married couple that exceeds $120,000 and throwing David and Carol squarely in the 22% ordinary income tax bracket. Such will be the reality for them beyond 2021.
While accelerating income and prematurely paying income taxes is rarely celebrated, David and Carol would be well-served to do just that in 2020. With approximately $20,000 of extra room in the 12% tax bracket this year, they could withdraw $20,000 from David’s IRA to fill up the 12% tax bracket. This results in an added tax of $2,400 ($20,000 * 12%) but allows them to avoid taxation of $4,400 (20,000 * 22%) in the future, when they will face a higher tax rate. The math is as follows:
It is important to note that the optimal way to achieve this result is always by way of a Roth conversion rather than merely an IRA distribution. David would simply open a Roth IRA and convert $20,000 from the IRA to the new Roth account. The benefit here is that any future growth or income on the $20,000 avoids taxation in the Roth IRA whereas that is not the case if he simply distributes this amount to the joint account.
The general advice for individuals with suspended RMDs in 2020 is to fill up the temporarily lower tax brackets before year-end. In this example, David and Carol fill up the 12% tax bracket – an extremely favorable tax rate that they are unlikely to ever see again in the future based on their expected taxable income. If they can withdraw tax-deferred funds that will eventually be taxed and only pay 12 cents for every dollar withdrawn, that’s going to be advantageous to paying 22 cents of tax for every dollar withdrawn in the future.
The larger the size of an RMD, the more valuable such a strategy can be. Additionally, there will be more value in this for taxpayers who temporarily drop from the 22% bracket to the 12% bracket in 2020 or from the 32% bracket to the 24% bracket than from the 24% bracket to the 22% bracket.
In outlining this general advice, it is also worth noting that the calculation is not always just about using Roth conversions to fill up the remaining room in a tax bracket. One complicating factor that impacts the calculation in many situations is the unique taxation of Social Security. Consider the following example,
Example 2: Assume all the same circumstances as the prior example with two exceptions. Instead of Carol’s pension income of $40,000 and combined Social Security income of $36,000, Carol has pension income of $25,000 ($15,000 reduction from Example 1) and David and Carol have combined Social Security income of $51,000 ($15,000 increase from Example 1).
Example 2 may appear to effectively mimic the first Example 1 as the reduced pension income is exactly offset by the increased Social Security income. However, there is a substantial difference from the first example because of the unusual way in which Social Security income is taxed. In Example 2, David and Carol face what is referred to as the “tax torpedo” – a dramatically elevated marginal tax rate as more of their Social Security income becomes subject to taxation. The following figures help explain. Without accelerating any additional income in 2020, their tax calculation is:
Although David and Carol receive $51,000 of Social Security benefits, only $25,119 is subject to federal income tax – based on a calculation called ‘provisional income’. As a result, they have $38,712 of taxable income and face $3,613 of federal tax.
In Example 1, the $20,000 Roth conversion (or IRA distribution) intuitively increased their taxable income by exactly $20,000. In this Example 2, the same $20,000 Roth conversion has a less-intuitive impact on taxable income. In fact, the $20,000 conversion increases their taxable income by an even $37,000 because an additional $17,000 of Social Security income becomes subject to taxation (plus the $20,000 Roth conversion). As a result, this conversion increases their tax liability by $4,440 – a marginal tax rate of 22.2%. ($4,440 tax / $20,000 conversion amount)
The high marginal tax cost of the Roth conversion in Example 2 means that David and Carol would be better served to bypass any retirement account distributions or Roth conversion this year and enjoy the benefits of the RMD suspension.
Other Factors to Consider
- Don’t forget the Qualified Charitable Distribution (QCD). We think nearly every American over age 70.5 who donates any amount to charity should use the qualified charitable distribution (QCD) as a way to reduce taxes. We will keep driving this home until the QCD is a mainstream concept but it is worth noting that the QCD is relevant to the topic above. We wrote about the unique QCD math related to 2020 earlier this year.
- Beneficiaries may matter to the calculus. The examples above use the expected future tax rates for David and Carol to assess the benefits of accelerating income in 2020. What also may matter is the expected tax rate of the ultimate beneficiaries. Suppose David and Carol have a financially successful son, Charlie, who they plan to leave all their assets to after their lifetimes. If Charlie earns a high income that will put him in the 37% tax bracket for the rest of his life, then it’s likely going to be advantageous for David and Carol to exercise Roth conversions of more than $20,000 in both Examples 1 and 2. By doing so, David and Carol are increasing the after-tax value of their estate for Charlie.
- Inherited IRA owners also need to evaluate the math. In our experience, some of the greatest benefit from this 2020 income acceleration strategy goes to retirees with an inherited IRA who have not yet reached age 70. This is to say that the above strategy is not just for individuals who have reached age 72.
- Concerned about higher tax rates in the future? All of the analysis above relies on the current tax code but we appreciate that plenty of Americans are concerned about tax hikes in the future. Any such tax increases – at the federal level – would make the income acceleration strategy even more valuable or, conversely, make the cost of doing nothing even more costly.
Closing Thoughts
This article obviously dives into the wonky tax weeds but if you want to ignore everything else, here’s the one critical takeaway: Anyone who was planning to enjoy the 2020 temporal RMD reprieve by doing nothing is possibly doing long-term tax harm by sitting idle. The examples above are highlighted to show both the benefit of the opportunity and the uniqueness of the calculation for each unique situation. For everyone with an RMD in 2020 that they were not planning to take, it will be valuable to communicate with your financial planner or accountant about the potential benefits of accelerating income in 2020 at a temporarily depressed marginal tax rate.
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