The strong market performance of 2023 means this year’s required minimum distributions (RMDs) are very likely to rise for many retirees. For most, we’d expect that retirement accounts have recovered a good amount of the assets withdrawn in the prior year’s RMD. While this is welcome news, it also creates additional challenges from a taxable income perspective. For lower-income clients, the additional income has the potential to impact their ability to qualify for subsidies in health insurance or reduced property taxes. For affluent clients, there is a potential to be pushed into a higher tax bracket and maybe even force a surcharge on future Medicare premiums.
Solutions for High Distributions
What can be done to help mitigate these higher distributions? First, for those already taking distributions, you have very limited options to truly move the needle. Assuming a retiree pursues an investment policy on their own or with an advisor, appropriate asset location is a way to potentially help marginally reduce future RMDs. For this to work, one must have a sufficient amount of assets in a taxable account such as a trust, joint or individual brokerage account. The general idea of appropriate asset location requires higher growth, tax-friendlier investments such as equities to be located in the taxable account.
From there, tax-unfriendly, lower-growth investments, such as taxable bonds, should be located in IRAs. Over time, the slower-growing assets in the IRA should lead to lower RMDs while maintaining the expected return profile of the portfolio as a whole. Additionally, the tax-friendlier dividend and capital gains generated by equities maintain the character of that tax treatment in the taxable account. In contrast, this treatment is lost in the IRA due to the ordinary income tax treatment of every penny that is removed from those accounts. There is no reason one needs to wait until they are subject to RMDs to practice appropriate asset location. In fact, to get the most out of this strategy, beginning as soon as possible is a best practice.
Converting to a Roth Account
For those who have yet to reach RMD age, Roth conversions are a surefire way to reduce future RMDs. For many, an inevitable drop in ordinary income occurs between the time they retire and when they begin taking social security benefits and, subsequently, RMDs. This window presents an astute investor and advisor with the chance to convert assets in a traditional IRA or 401(k) to a Roth IRA.
Converting to a Roth IRA is a taxable event. Any assets converted will be added to income and taxed at the rate applicable to the taxpayer. While no one enjoys paying taxes, in many cases the tax rate in the time period after retirement and before the beginning of Social Security and RMDs will be lower than the tax rate they paid while working. It’s also lower than the tax rate they will pay once Social Security and required distributions begin.
The above strategies are time-tested ways for an investor to pick up after-tax return over the long run and help mitigate RMDs he or she may not rely upon. The analysis and methods required to take advantage of these opportunities can be difficult for the DIY investor and traditional broker to effectively and accurately implement as there are many moving parts. We suggest the use of a fiduciary wealth advisor when carrying out these types of strategies.
