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Tax Breaks


LOWER TAXES ON REQUIRED MINIMUM DISTRIBUTIONS


WHEN YOU TURN 72, YOU’LL HAVE TO START TAKING MINIMUM DISTRIBUTIONS FROM YOUR
TRADITIONAL IRA AND 401(K). THESE STRATEGIES WILL HELP TRIM WHAT YOU OWE UNCLE
SAM.

by: Sandra Block
November 23, 2021
November 23, 2021

Photo by Marty Lee

The buoyant stock market has swelled the amount of money Americans have in their
retirement savings plans, which is undoubtedly a welcome development for seniors
who will need that money to live on. But most of the more than $13 trillion in
savings is stockpiled in tax-deferred plans, which means retirees will
eventually have to pay taxes on it. And depending on the size of the account,
that tax bill could be significant.

To prevent retirees from avoiding taxes forever, the IRS requires owners of
traditional IRAs and other tax-deferred accounts, such as 401(k) plans, to take
minimum withdrawals based on their life expectancy and the balance of their
accounts at year-end. The Setting Every Community Up for Retirement Enhancement
(SECURE) Act, which was signed into law in December 2019, increased the age at
which you must begin withdrawing money from 70½ to 72. Legislation pending in
Congress would gradually increase the age for required minimum distributions to
75 by 2032 (see below).

But unless Congress decides to eliminate RMDs altogether, which seems unlikely,
you (or your heirs) will eventually have to withdraw the money in your
tax-deferred accounts. And that could be a problem, because as your untapped
balance grows, so does the amount you’ll be required to withdraw, along with
your tax bill. RMDs are taxed as income, so a large withdrawal could vault you
into a higher tax bracket. In addition, more of your Social Security benefits
could be taxed, you could lose out on certain deductions and credits tied to
your modified adjusted gross income, and you could pay higher premiums for
Medicare parts B and D.




Below we describe ways to reduce the size of your required withdrawals and,
consequently, your tax bill. All involve trade-offs—paying taxes now instead of
later, for example, or giving some of your savings away—so consider your options
carefully.


TAP YOUR IRA FOR CHARITY

If you’re 70½ or older, you can donate up to $100,000 a year from your IRAs to
charity via a qualified charitable distribution, and after you turn 72, the QCD
will count toward your required minimum distribution. A QCD isn’t deductible,
but it will reduce your adjusted gross income, which besides lowering your
federal and state tax bill can also lower taxes on items tied to your AGI, such
as Social Security benefits and Medicare premiums. If you don’t itemize—which is
the case for many retirees—a QCD provides a way to get a tax break for your
charitable gifts.

David Bayer, 89, a former Navy captain who lives in John Knox Village, a
retirement community in Pompano Beach, Fla., has been making qualified
charitable distributions from his retirement savings since he turned 70½. His
wife, Jackie, who is 75, also started making QCDs when she was required to start
taking withdrawals from her savings. The Bayers contribute to several
philanthropic causes, including their church and an organization that supports
orphanages in Africa. Jackie also used a QCD to set up a scholarship fund at
Purdue University, her alma mater.


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“We feel that we’re at a spot where we’re fortunate to be able to give back,”
David Bayer says. “It’s nice to know that Uncle Sam is chipping in his share.”




The maximum amount you can donate each year through a QCD is $100,000, but you
can donate less than that, and many retirees do. Randy Bruns, a CFP in
Napierville, Ill., says he often advises retirees who are already making
charitable contributions to channel their gifts through a QCD.

Make sure the donation is made directly from your IRA to the charity; otherwise,
it won’t qualify for a QCD. You can’t make a QCD to a donor-advised fund or
private foundation, and the recipient must be a 501(c)(3) charity registered
with the IRS, says Mari Adam, a CFP with Mercer Advisors in Boca Raton, Fla.
That’s not always clear: Adam says she recently discovered that a philanthropic
group she has supported was not a qualified charity (it subsequently registered
with the IRS). Check the charity’s website, or ask the organization for a tax
identification number.

Keep good records so that you won’t be taxed on the distribution when you file
your tax return. Most tax software, or your tax preparer, will walk you through
the process to report your QCD.

 * How to Report an IRA Charitable Distribution on Your Tax Return


CONVERT TO A ROTH

When you convert money in a traditional IRA to a Roth, you must pay taxes on the
amount you convert (although part of the conversion won’t be taxed if you’ve
made nondeductible contributions to your IRA). But after the conversion, all
withdrawals are tax-free, as long as you’re 59½ or older and have owned a Roth
for at least five years. Unlike traditional IRAs and other tax-deferred
accounts, Roths aren’t subject to required minimum distributions, so if you
don’t need the money, you can let it continue to grow, with no obligation to the
IRS.




Converting to a Roth is also a hedge against future tax increases. The Biden
administration has proposed increasing the top tax rate on ordinary income from
37% to 39.6% for joint filers with taxable income of more than $450,000 and
single filers with taxable income of more than $400,000. And even if those
proposed tax rates fail to get through Congress, the 2017 Tax Cuts and Jobs Act,
which lowered income tax rates across the board, is scheduled to sunset in 2025.
Unless it’s extended, tax rates will revert to their higher, pre-2017 levels.
“We tell our clients, ‘You may never see tax rates this low in your lifetime,’ ”
Bruns says. Plus, if you expect to leave funds in your IRA to your children,
converting to a Roth could lower the taxes they’ll pay on their inheritance.

However, a large Roth conversion, like a large RMD, could push you into a higher
tax bracket, increase taxes on Social Security benefits, and trigger a
high-income surcharge on your Medicare premiums. And it doesn’t make much sense
to convert if you’re in a high tax bracket now and expect to be in a lower one
in the future.

 * When and Why You Might Consider a Strategic Roth Conversion

“My advice on this is, don’t aim too big,” because you may live to regret it,
Adam says. She says her clients usually convert fairly modest amounts—typically
$10,000 to $20,000 a year. Before 2018, taxpayers who converted an IRA to a Roth
had until the tax extension deadline of the year following the year they
converted—typically October 15—to change their minds. That’s no longer
permitted, so it’s important to get it right the first time.




You can keep the cost of a conversion down by converting during the period
between the year you retire and the year you’re required to take RMDs. Your
income will likely drop after you stop working, and until you’re required to
start taking distributions, you have some control over the amount of income you
receive each year. With the help of a financial planner (or a good software
program), you can calculate how much you can convert without moving into a
higher tax bracket. Once you’ve started taking RMDs, you can’t convert money in
a traditional IRA (or other tax-deferred accounts) to a Roth until you’ve taken
your required distribution, which could result in a hefty tax bill.

 * Your Guide to Roth Conversions


OTHER STRATEGIES FOR RMDS

Even if you don’t need the money, taking small distributions from your
tax-deferred accounts during your low-tax years could be a smart tax-planning
strategy. The distributions will reduce the size of accounts, which will mean
smaller RMDs down the road, says Kristin McKenna, a CFP with Darrow Wealth
Management in Boston. As is the case with Roth conversions, it’s a good idea to
figure out how much you can withdraw each year while remaining in your current
tax bracket.

Taking early distributions offers other benefits. You can use the extra income
to delay filing for Social Security, ideally until age 70, so you can take
advantage of delayed retirement credits. And as is the case with conversions,
you’ll be able to take advantage of current low tax rates.

Another way to reduce RMDs is by buying a deferred income annuity. You can
invest up to 25% of your IRA or 401(k) account (or $135,000, whichever is less)
in a type of deferred income annuity known as a qualified longevity annuity
contract (QLAC). When you reach a specified age, which can be as late as 85, the
insurance company turns your deposit into payments that are guaranteed to last
the rest of your life.




The portion of savings used for the annuity is excluded from the calculation to
determine your RMDs. For example, if you have $500,000 in an IRA and transfer
$100,000 into a QLAC, your RMD is based only on the remaining $400,000. This
doesn’t eliminate your tax bill—it just defers it. The taxable portion of the
money you invested will be taxed when you start receiving income from the
annuity.

QLACs offer other advantages to retirees who want guaranteed income later in
life. Because you’re deferring the income stream, payouts are much higher for
deferred income annuities than they are for immediate annuities, which start
payouts right away. For example, a 65-year-old man who invests $100,000 in an
immediate annuity will receive a payout of $493 a month, according to
www.immediateannuities.com. That same amount invested in a deferred-income
annuity that begins payments at age 80 would pay $1,663 a month.

 * Annuities: How to Turn Retirement Savings into Retirement Income


POSTPONE DISTRIBUTIONS UNTIL AGE 75?

Congress isn’t finished tweaking the rules for retirees. Legislation dubbed
SECURE Act 2.0 would make a number of changes to the rules governing retirement
savings, including the age at which required minimum distributions start.

The proposed legislation would raise the RMD age from 72 to 73 starting on
January 1, 2022; to age 74 on January 1, 2029; and to 75 on January 1, 2032.

Proponents of a higher age for RMDs argue that life expectancies have increased
since RMDs were created, which means seniors need more time for their money to
grow. In the mid 1970s, when the Employee Retirement Income Security Act, or
ERISA, first authorized IRAs, U.S. life expectancy at birth was 72.6 years,
according to the Centers for Disease Control and Prevention. While life
expectancy declined between 2019 and 2020, primarily due to the pandemic, it’s
still much higher, at 77.3 years, and many seniors live well beyond that
average.




Another provision in SECURE Act 2.0 would greatly reduce the penalty for failing
to take a mandatory withdrawal. Currently, the penalty is 50% of the amount you
should have withdrawn, one of the harshest penalties in the tax code (although
you can qualify for a waiver, depending on your circumstances). The legislation
would reduce the penalty to 25%, and if the mistake is corrected in a timely
manner, it would be further reduced to 10%.

 * The Downside of Delaying RMDs


SMART PLANNING

The first SECURE Act may have provided a break for retirees who need more time
for their savings to grow, but it could increase taxes on funds they leave to
their heirs.

Before 2020, beneficiaries of inherited IRAs (or other tax-deferred accounts,
such as 401(k) plans) could transfer the money into an account known as an
inherited (or “stretch”) IRA and take withdrawals over their life expectancy.
That enabled them to minimize taxable withdrawals and allow the untapped funds
to continue to grow.

Now, most adult children and other non-spouse heirs who inherit an IRA (or
inherited one on or after January 1, 2020) must deplete their inherited IRAs
within 10 years after the death of the original owner (see Minimizing Taxes When
You Inherit Money). Spouses still have the option of rolling the money into
their own IRAs or taking distributions based on their lifetimes.

Non-spouse heirs who inherit a Roth also have to empty the account in 10 years,
but the distributions are tax-free. If you want to leave your adult children a
tax-free legacy, converting some of your IRA funds to a Roth could be a smart
estate-planning strategy. But the strategy’s value depends on your family’s
financial circumstances. If your heirs are in a lower tax bracket than you are,
you may be better off leaving them a traditional IRA—and the tax bill.

 * I Inherited an IRA. Now What?


 * IRAs
 * required minimum distributions (RMDs)
 * Roth IRA Conversions
 * Tax Breaks

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