Tackling Retirement's Tricky Tax Questions

This Week's Quote:

"Television is not real life.  In real life, people actually have to leave the coffee shop and go to jobs"
                        - Bill Gates

“For the vast majority of people, the issue of how to save, invest and spend in retirement is the hardest, nastiest problem in finance,” says William Sharpe, the Nobel laureate economist who devised the Sharpe ratio, a measure of risk-adjusted return. 

Congress hasn’t made this tough problem easier. When lawmakers can agree at all, they layer poorly drafted law upon law, leaving both the Internal Revenue Service and savers to confront a maze of confusing provisions. 

But, given the demise of pensions, savers planning for retirement have to cope. Here are answers to questions readers asked after last week’s column.  

Will my children or grandchildren have to take annual required minimum distributions, or RMDs, when they inherit my IRAs or 401(k)s? 

Some will and some won’t. Here’s the crazy quilt of rules for nonspouse heirs of IRAs explained by Ed Slott, a CPA and retirement specialist.  401(k) funds are typically rolled over to IRAs.

Roth IRAs first: If the Roth owner died before 2020, the heir must take annual payouts. But these tax-free payouts are often small and can run for decades, which is why they’re often called Stretch IRAs. Meanwhile the funds in the account can grow tax-free.   
 
If the Roth owner died in 2020 or after, the heir has 10 years to drain the account of its tax-free funds with no annual RMDs required under IRS REG-105954-20, p. 253. So account assets can grow tax-free for that period.  

Heirs of traditional IRAs face more complexity. If the owner died before 2020, then the heirs must take annual payouts, which can go on for decades under the Stretch rules. The payouts will typically be taxable, and there’s no waiver of RMDs for 2023. 

If the traditional IRA owner died in 2020 or after and was already required to take RMDs, then heirs typically have 10 years to drain the accounts, and they have to use the Stretch rules to take annual payouts during that period for years 1 through 9. Often this results in smaller withdrawals before a large final payout, so some heirs withdraw more earlier to avoid a tax-rate jump in year 10. There’s no prohibition on withdrawing more than required, only less.   

Because of confusion over RMDs for these heirs due to a law change, the IRS has waived these payouts for 2021, 2022 and 2023.

If the owner of the traditional IRA wasn’t yet required to take RMDs, then the heirs don’t have to take annual payouts—but they may want to make withdrawals to avoid a tax hit in year 10. 

Note: More generous rules apply for some groups of heirs of traditional IRAs whose owners died in 2020 or after, such as minor children (but not grandchildren). See IRS Publication 590-B. 

Can IRA owners taking annual RMDs still contribute to traditional or Roth IRAs and 401(k)s?   

Yes—but they must have earned income such as from wages or self-employment at least equal to their contribution. They also need to keep taking RMDs annually. 

Can Roth IRA or Roth 401(k) withdrawals be used to manage tax rates? 

Yes. Say a saver has a surge of taxable income from contract work or another source. That could raise income taxes, bring higher Medicare IRMAA premiums or trigger the 3.8% net investment income tax. This person might be able to use tax-free Roth withdrawals to provide cash and reduce taxable income.

Caveat: This strategy requires flexible income, and Social Security payments and pension payments typically aren’t flexible. But if the saver withdraws more than the RMD, as many do, he could reduce these taxable withdrawals and use Roth payouts to meet cash needs. 

I’ve now realized my wife will get hammered on taxes if I leave my large traditional IRA to her. Can I leave it to other heirs? 

Yes. This question refers to the “widow’s penalty,” which many aren’t aware of. It arises when one spouse dies and the survivor typically must switch from married, filing-jointly tax status to single-filer status. 
 
As a result, higher tax rates take effect at lower income levels. However, RMDs may not drop much if at all—and that income can push the survivor into higher tax rates, especially as RMDs typically rise with age. It’s not unusual for the survivor’s top tax rate to jump from 12% to 22%, or from 24% to 35%, say advisers.  

A saver facing this problem could instead leave all or part of a traditional IRA or 401(k) to other heirs. This move could reduce the spouse’s tax rate, provided it leaves enough to live on. However, the nonspouse heirs of traditional IRAs or 401(k)s often must drain the account within 10 years as described above.  

Having funds in Roth accounts can also help. Some surviving spouses even do Roth conversions in the year of the spouse’s death to benefit from married-filing jointly brackets before their filing status changes.  

While working, I saved aggressively in traditional IRAs and 401(k)s. Now I’m 70 and I find I’ll be in a higher tax bracket when RMDs begin, which will also raise my Medicare premiums. How can I manage this? 

It may be hard; perhaps get professional help tailored to your details. But you still have a couple of years before RMDs kick in at 73. So consider Roth conversions before then to reduce your traditional account.

Doing Roth conversions while taking RMDs is allowed, but the RMD amount itself cannot be converted. So the conversion amount stacks on top of the RMD, and that can raise the owner’s tax rate.   

If you are charitably inclined, make your donations directly from traditional IRA assets using Qualified Charitable Distributions starting at age 70 ½. This provides a tax break and removes funds from your account without creating taxable income that can raise Medicare IRMAA premiums or other taxes.  

Can Roth accounts help lower the cost of “Obamacare” health coverage or tax on Social Security payments? 

Yes to both. Under current law, tax-free Roth withdrawals don’t count as income for these purposes. 

However, many people receiving Social Security benefits will find it hard to avoid tax on this income. The tax thresholds for this aren’t indexed for inflation.  

Can my company’s matching funds go into my Roth 401(k)? 

As of 2023, some employer contributions to a worker’s 401(k) can be to a Roth 401(k). However, the employee owes the tax on these contributions, and this benefit is optional for companies.

Savers who are self-employed and have Solo 401(k) plans may find this move easier, because they are the employer as well as the employee. Check with the plan custodian.
                                                                                                  
Credit goes to Laura Saunders, published August 11, 2023 in The Wall Street Journal
 
Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
 
This Week’s Author, Belinda Stickle

-until next week