Save on Retirement Taxes: Updates to RMD Rules on ...
The government recently clarified rules for required minimum distributions on inherited IRAs. If you have a 401k, if you have a retirement account like an IRA, these rules apply to you, and you should be aware in order to make better decisions to keep more money in your pocket. Now, you may be a parent that has a retirement account and you want to pass that on to your children or grandchildren and maximize the amount of money that they receive, or you may receive or be expecting to receive an IRA at some point in the future. These clarifications that were recently released may impact how much money you get to keep in your account.
We’re going to go through some case studies, we’re going to talk bigger pictures so you can understand this from a financial planner’s perspective with the goal of helping you to make better decisions so you keep more money in your pocket.
The Elimination of the Stretch IRA Concept
These rules apply to retirement accounts that were inherited after 2019. Now, the genesis of this was the SECURE Act that was passed several years ago. Of course, like most pieces of legislation, it had some gaps and some things that weren’t quite clear. Here we are four and a half plus years later, and we’re finally getting some clarity on what the original legislation intended. If you inherited a retirement account after 2019, you are subject to these rules. What the SECURE Act did was eliminate the stretched IRA concept. That concept is still there for all retirement accounts if they were inherited prior to 2020.
The stretched IRA said when you receive an IRA account, you could stretch it out over the course of your life, meaning you have to take very small distributions based on your life expectancy for your entire life. There was no deadline for the entire account to be distributed. The government said, “No, we can’t allow you to stretch these accounts out over the course of your lifetime. They’ve been tax-deferred, we need to get our tax revenue. We’re going to pass the SECURE Act, which is now going to force distributions in their entirety from your retirement account within 10 years of the date of death.”
Those of us in the financial planning world and the tax world, we had tons of questions because the legislation, the SECURE Act, did not address the rules surrounding all of the specific circumstances that we deal with on a daily basis when planning for your retirement. Believe it or not, retirement account law, as far as distributions, inherited retirement accounts, required minimum distributions, this is one of the most complex areas of the entire tax code. There are so many specific circumstances that they’ve carved out different sets of rules for calculations that it’s very complex. We’re going to go through at a high level what this means for you and your retirement.
Again, talk about some financial planning concepts here, but first, I want to just summarize on the basics of required minimum distributions and what the clarification to the SECURE Act says so we can get right to helping you understand what we’re going to go through.
Inheriting Retirement Accounts: What You Need to Know
Okay, so first, required minimum distributions. Once you turn either 73 or 75, depending on your age now, you are forced to start taking money out of your retirement account.
Now, at age 73 or 75, that is called your RBD, your required beginning date. This is very important because if you inherit a retirement account, these rules will apply to you only if the person you are receiving that account from had hit the age of their required beginning date. Basically, if they have begun or had begun taking required minimum distributions, you now have to continue required minimum distributions, but you use a different IRS table and a different calculation, and we’re going to go through that in a few minutes.
If the person you are receiving the retirement account from had not started required minimum distributions yet, meaning they did not reach their RBD, the required beginning date, then you do not have to take annual distributions from that inherited IRA, but you do still have to fully distribute it within 10 years of the date of death. Now, how do you calculate 10 years from the date of death? We’re going to call him Jim for this hypothetical example. In the year that Jim dies, let’s say it’s right now 2024, Jim passes away.
If Jim had already started his required minimum distributions, that RMD still must come out of Jim’s retirement account by December 31st of this year based on the calculation that he had been taking his entire RMD percent or his entire RMD life. Let’s say he was 76. If Jim was not RMD age, an RMD does not have to come out of his account based on his calculation because there is no calculation by the end of this year. You inherit the account next year, so 2025, so 10 years after the date of death. You have 10 years starting in 2025.
At the end of that 10-year point, that retirement account has to be fully distributed, and taxes have to be paid 100% on whatever the balance is, and that’s at federal income tax rates.
Basics of RMDs and How to Calculate Yours
First, I want to start with a very basic understanding of what required minimum distributions are for those of you who have a retirement account, so you can understand how to calculate years in case you do not. The SECURE Act moved it from age 70 and a half to age 72 at first, and then SECURE Act 2.0 changed it to age 73 or 75. We have the RBD, required beginning date, here at 73.
You take your retirement account balance as of December 31st of the previous year, you divide it by this factor right here. This is the Uniform Lifetime Table. Divide the $1 million by the 26.5. The more simple way to do it for me is simply multiply by 3.78%. These two are the exact same. If you have a $1 million account, you’re looking at $37,800 for your first required minimum distribution. As you can see, the percentages increase, so you’re required to distribute more and more from your retirement account as you progress through life.
If you’re first time watching this channel, please watch some of the tax planning videos, watch some of the Roth conversion videos because this is a ticking tax time bomb for many of you because conventional wisdom has always said defer your retirement accounts as long as possible. If you do that and you get these very large balances, then you’re stuck distributing an increasing percentage throughout retirement that pairs with your Social Security, your dividends, any other income that you may have, and oftentimes you find yourself in very high tax brackets.
Using The IRS Single Life Expectancy Table for Those Who Inherit
You can either take your account balance, divide by this number, or take your account balance and multiply by here.
This is the Uniform Lifetime Table again. Now, if you inherit or when you inherit a retirement account, you don’t use this Uniform Lifetime Table, you have to use the IRS Single Life Expectancy Table. You simply find your age. If you inherit it at age 42, your life expectancy is 43.8, so you take that account balance, you divide by 43.8, that is your required minimum distribution for that year. Just to clarify, if the person you inherited the account from had not reached their RBD yet, the required beginning date, you do not have to take distributions calculated off this Single Life Expectancy Table. You do still have to fully distribute that account and pay taxes at the end of the 10th year.
I want to briefly clarify how you calculate the 10-year period. I’m going to use a hypothetical person here, Jim. Let’s say Jim is 75 years old, he passes away today. He’s already reached his required beginning date. If he had not taken his RMD out for this year, someone wants to take it for him by December 31st, 2024, the end of this year. Then you inherit the account. From 2025 and on, that’s the first year of inheritance, then you go to the second, third, fourth, fifth. By the end of the 10th year, 100% of that retirement account must be fully distributed. In this instance, because Jim had reached his required beginning date, he was already taking RMDs.
You have to finish taking his RMD, and then your 10-year period starts in 2025. Now, because he was taking his required minimum distributions, you have to continue to take required minimum distributions from that retirement account. You use the IRS Single Life Expectancy Table. If you’re age 42, your factor is 43.8, and of course, the IRS didn’t say, “You know what? Just come back to this table every single year and look at your age.” You take your starting age here, 42, you get your factor, and then each year from that point forward, you subtract one.
Next year, you’re going to divide the account balance by 42.8, and then the following year, take the account balance as of December 31st, subtract two from this one, you’re at 41.8. If Jim had not started his required minimum distributions, you do not have to go to this table, you do not have to take any money out until the end of that 10th year.
Eligible Designated Beneficiaries: Special Considerations
Now, everything we just went through as far as the 10-year distribution date and the annual RMDs applies to those that are considered non-eligible designated beneficiaries. It’s a fancy way of saying you’re most likely a child of the person who passed away, someone who’s greater than 10 years, younger than the person who died.
Here is the definition for an eligible designated beneficiary, which if you are one of these, there’s an entirely different set of rules that apply. We’re going to spend some time talking about the spousal options because that’s going to be the most popular of those of you watching this video. You’re going to want to know these choices, but you’re also an eligible designated beneficiary if you’re a child of the participant who has not reached the age of 21, you’re disabled, chronically ill, and not more than 10 years younger than the participant. This is likely going to be a brother or a sister, a niece possibly, a cousin.
Now, disabled or chronically ill, there are specific definitions that you would have to meet in order to attain this status. You’re going to want to talk to your CPA or an attorney to see if you qualify. Now, the one category here that I do want to talk about is the not more than 10 years younger, but what happens if you’re older than the person who passed away? Special rules apply there. This is an election that you have to make and the IRS, again, they’ve not actually provided guidance on how to make this election, but they did clarify that they’re going to give you a choice. Let’s say Susan is 79 and Jim is 76.
Jim passes away, Susan inherits all of the retirement account. She gets to choose, does she want to base those distributions that she has to take off the longest life expectancy? She can choose to take distributions off Jim’s life expectancy and not hers because his life expectancy is better than hers. The rest of the rules for these other individuals, they’re going to be different depending on if you’re a spouse or a non-spouse and if the account was inherited prior to or post that required beginning date and they’re different. Some of them are similar.
Most of them, if you have begun required minimum distributions at the date of death, most of these scenarios, except for the surviving spouse, you have to continue required minimum distributions. Some of them will require a full distribution by the end of the 10th year, some of them will not. Again, it’s very complex. Maybe I’ll do a separate video on it, but again, search out somebody if you are a beneficiary and fall into one of these scenarios other than the surviving spouse or the participant that can help you understand that. Now, you can see this is tremendously complex.
You’re going to want to find the appropriate professional, whether it’s a CPA, whether it’s a tax attorney, whether it’s an investment advisor, or certified financial planner or professional who is well-versed in retirement account distribution rules. Mistakes aren’t quite as punitive as they used to be, but at the same time, you don’t want to deal with the IRS if you make mistakes. There are still costs and fees associated, late penalties, interest, et cetera. You want to get this right. There is one more thing before we get into some of the planning considerations and also big picture concepts that you have to know to properly plan for these R&B rules.
Term to Know: ALAR: “At Least As Rapidly”
When you begin to research, I want you to be familiar with the term that’s known as at least as rapidly. The way it sounds is that if someone dies and they’re taking required minimum distributions, you’ll see this phrase used as it pertains to the beneficiary. A lot of the writings will say the beneficiary must take distributions ALAR, at least as rapidly, as the person who died. That makes it seem like, just on the surface, that if I’m taking $20,000 from the IRA as a living person and then I pass away, well, the person who dies, they must take distributions at least as rapidly as the person that was living.
You would think that’s $20,000 per year minimally that they have to take, but when you do the calculation on the single life expectancy table, it will be less than $20,000 a lot of times. That phrase, at least as rapidly as it applies to the beneficiary and how much money they must distribute from the retirement account, the one that they inherit, it only applies to the frequency, the timing of distributions, not the magnitude or not the amount. You could take a $2,000 RMD as someone who has inherited a retirement account, whereas the person who died was doing $80,000 RMDs.
You will satisfy that at least as rapidly requirement, even though on the surface, it doesn’t sound like you’ll be draining that account as rapidly as the person who is living, but it just applies to the frequency and the timing, not the amount of the distribution. Okay, moving on. I have this here because this is the 260-page document that helps to clarify these RMD rules. Again, it doesn’t address everything. If you want to look it up and try to go through it, try to read it, or you want to search the document, it’s a publication, I believe it’s 2024-14542. Here is the web page. You can pause the screen, check that out. Again, a lot of legalese.
Even I would probably need an attorney to go through and understand it. I did try to start reading it and it’s just not worth my time. I’d rather pay someone to do that and take the knowledge from them. That’s that if you want to take the time to go through it.
Big-Picture Implications of the SECURE Act
All right, big-picture ideas. Those of you who have either listened to my radio show or followed the YouTube channel here for many years, you’ve heard me talk about this before. I have said from day one that I believe the SECURE Act, the original version, 1.0, that required 10-year full distribution of retirement accounts is part of a larger plan. Now, I’m not normally into conspiracy theories here and this could maybe fall under that category.
Again, I follow the math, I follow the numbers, and I have common sense. The original IRA distribution rules allowed you to stretch that account over the course of your life. Someone in Congress got together and said, “You know what? That’s way too long. We need to force this money out of the account.” They included that language in the SECURE Act that forces that money to be distributed within 10 years. Now they went back and said, “Okay, you must also continue to take required minimum distribution,” so we’re incrementally getting some money, and then at the end of the 10th year, you must fully distribute that account.
Now, there are 10,000 people retiring every single day in this country, and there have been for many years, and there will be, continue to do so for many years. A simple Google search shows us that we have $38.4 trillion in retirement accounts right now. Now, again, using some simple time value of money calculations, we’re going to have some distributions coming out of those accounts, but of course, they’re going to continue to grow most likely. Let’s say that number doubles to $76 trillion over the next 15 years.
Now, because of the SECURE Act, every single dollar inside those retirement accounts will be fully distributed most likely within the next 40, 50, 60 years because you have some younger people, you have some older people that may live longer, but it’s a series of cash flows that the government can now depend on. First step in this grander plan, I’ve always said, was to pass some piece of legislation that forced people to distribute money from those retirement accounts, completely eliminate the stretch provision. Step two, of course, simply raise taxes in the future because we have this pending pot of gold that’s out there that we are going to get a large chunk of.
If people don’t plan, if they don’t think about this ahead of time, when you add federal taxes at the highest marginal tax rate plus state taxes, they’re looking at 50%, 55%, maybe 60% plus of your retirement account going to their coffers.
Scenario Example When the Trump Tax Cuts Will Expire
Now, how do you get to that top marginal tax rate? It’s quite simple. At that 10-year period, once the money goes to whomever is going to receive it and they have to distribute it within 10 years, let’s say you have a child, maybe a son and he’s married and they have a two-income household. They’re making $150,000 a year, then they receive a million-dollar retirement account. Right over here, I’ve done the simple math.
Now, this is based on what the tax rates will be, as of we know, when the Trump tax cuts expire. We have $150,000 of wages, no other income, no dividends, no investments, no rental income, nothing else, a $1 million retirement account distribution. Keep in mind, when they inherit it, let’s say they inherited $500,000, they don’t need the income, they’re working. They let it grow. That $500,000 turns into a million by the end of year 10 at a 7% assumed rate. You actually only pass down a $500,000 here. $376,000 of it is going to go to the government.
It’s the top marginal tax bracket once the Trump tax cuts expire is 39.6, but the effective rate on this, because so much of that income falls into the top bracket, is 33.2. Right now, if you’re in California and you’re in the top state income tax bracket, which I believe is around 13%, you’re looking at roughly 45%.
If you’re in New York, New Jersey, Illinois, one of these states that has high state income tax, 10 years, 15 years, 20 years from now, if federal income taxes are higher, if state income taxes are higher, you can see how we can pretty quickly get to 40%, 45%, 50%, 55%, 60% plus of these retirement accounts not going to those who you want it to go to, to whom you want to receive it, but going to the government instead. Brought up the debt clock here again. I’ve been showing this a little bit more recently because we’re getting into election season where taxes are going to be a big discussion. Spending obviously is a big discussion.
Both parties seem to spend pretty recklessly, and I like to bring this up because for those of you who have not seen it, it really is eye-opening. Right now, almost $35 trillion in the national debt, and they have this little time machine feature. If you just fast forward four years at current spending rates, projected spending, up to almost $47 trillion in total debt over just increase from the next four years. Again, the problem with our national debt in the annual deficit is so much of it is driven by constitutionally mandated expenses, so Medicare, Medicaid, Social Security, the defense budget, interest on the debt, the Affordable Care Act is now a constitutionally mandated expense.
Everything else is part of the discretionary side of the budget, so Homeland Security, the CIA, FBI, every other agency and bureaucracy, all of that is discretionary, and that’s what they fight over when it comes to these budget battles. We have so many people retiring, so many people going on to Medicare and Social Security. It’s only going to continue to massively increase. We’re almost at the point where we are borrowing 100% of the discretionary side of the budget. We’re very close. Last I saw, we were at 96%, 97%, but that was a couple of years ago. Again, we’re not trying to scare you with this. It’s just the facts. We spend far more than we bring in.
The only way the government gets tax revenue is through taxation, and I’ve long said that the SECURE Act was just the first part of a two-part strategy. Force money out of the retirement accounts, this $38.4 trillion that they just have sitting there, this big piggy bank, and in the future, at some point, we’re going to raise taxes and get a larger slice of this big piggy bank.
Roth Conversions: A Strategic Tax Planning Tool
Okay, so this is one of the reasons why we’re a big proponent of Roth conversions. When we do the analysis, it does make sense for most people, mathematically, to consider Roth conversions, but there’s these components to the Roth conversion consideration that maybe mathematics have nothing to do with it.
Even if it doesn’t make sense financially, what Roth conversions do, and that’s where you’re taking money from the IRA and putting it into the tax-free account, they remove the risk of taxes being higher in the future, new taxes being introduced. As a matter of fact, we just did a video, I believe the title was 12 Reasons to Consider a Roth Conversion, and if I remember correctly, I don’t think many of them had to do with the math itself, maybe one or two. Roth conversions, we’re a big proponent of this, and ultimately, what it allows you to do is to simply get control of when you pay tax and how much tax you pay and you have the ability to spread it out, so you’re doing incremental conversions over a series of years.
Now, when strategically done, you can maximize the benefit and the return on those dollars that you pay to the government and you keep in your tax-free account, as opposed to just doing these massive, large, lump-sum conversions. Everyone’s situation is a bit different, everyone’s goals are a bit different, but I do encourage you to strongly consider, do the math, have the conversation, talk to people who are knowledgeable to see how much, at what frequency, over what timeframe could Roth conversions make sense to you because you’re increasing the tax-free portion of your estate and not keeping so much money inside that tax-infested account.
Planning for the Future: Conversations with Your Children
The second financial planning consideration here, I guess really the two-fold type thing, one, talk to your kids. I believe it’s next year, we’re going to start a pretty big series where we go into how parents and grandparents can talk to kids, grandchildren about money, planning strategies, what they’ve done. There’s a saying across multiple timeframes, multiple parts of the world where wealth is essentially lost by the third generation. There were some studies done fairly recently on this over the past 20 years, and all of the studies concluded the same thing, that the number one reason that wealth is lost after the third generation is poor communication.
Talk to the kids, talk to the grandkids, if they’re going to inherit money, make sure they have this understanding. Now, once they have the understanding, the next step to do, of course, is financial planning. Let’s say you’re going to inherit money seven years before retirement and you have this big IRA and you have to take required distributions. Do you take more than the minimum or maybe do you just take that minimum, and then defer that retirement account as much as possible until year 7 when you retire and you have no other income, and then you take a lot more out of it?
Now, what about if you’re in that same situation, but you are retiring prior to 65? If you depend on that retirement account, it’s going to increase your distributions, your taxable income. Now you’re going to have to pay health insurance premiums at going rates of maybe $2,000 a month for a family of two. Maybe you alter your distribution strategy when you inherit that retirement account to match what your living needs will be based on your income today when you’re going to retire. These are pieces of the puzzle and they all need to be fit together. Inheriting a retirement account simply introduces another piece to the puzzle that needs to be considered and planned for.
Of course, there are a million other scenarios that may apply to you in your situation, and inheriting a retirement account simply complicates that. It’s not a bad thing, it just complicates it. One last thing to clarify here. SECURE Act was passed in 2020. If someone passed away in 2020, you were not required to take RMDs during those years, 2020, ’21, ’22, ’23. Now the IRS is not resetting that 10-year period with these new regulations that were clarified in release. If someone died in 2020, you still have 10 years to fully distribute that account. You simply do not have to go back and take distributions for the years that you’ve missed.
This RMD requirement applies to 2025 and beyond. Even here in 2024, you do not have to take an RMD if you inherited an account from someone who was already taking required distributions. A lot of complex material here. Hopefully, we were able to shed a light on some of the bigger picture concepts, as well as help you understand some of the requirements under the regulations that we finally received clarification from the IRS from. Go back, re-watch it, send it to a friend or family member that may benefit, and we’ll see you very soon.
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