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required minimum distributions

Q&A: Maxing out retirement contributions? Beware of future tax issues

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Dear Liz: I work for a local government and am trying to decide when to retire. I will receive a pension and have put away as much money as I could afford in my 457 deferred compensation plan. I invested it in a Standard & Poor’s 500 index fund that has performed well and is now worth $1.3 million. I also have a non-sheltered brokerage account of seven figures and no debt. Last year, I contributed vacation time and money to maximize my 457 contribution of $46,000. This year (and next unless I retire), I am likewise maximizing my contribution and contributing $46,000 each year. But periodically our monthly expenditures have exceeded my monthly income after the contribution and I have had to dip into the brokerage account to make up the difference. Does that make financial sense to do if needed or should I consider scaling back my contribution?

Answer: When you’re behind on saving for retirement, maximizing your contributions to tax-deferred plans in your final working years can be a smart move.

You, however, have a large amount of savings as well as a pension, so you may face a different problem: higher future taxes. Diligent savers can find themselves pushed into a higher tax bracket when required minimum distributions (RMDs) kick in. RMDs used to begin at age 70-½, but now start at age 73 for those born between 1951 through 1959 and will rise to 75 for those born in 1960 and later.

Many people with large tax-deferred retirement accounts can reduce their lifetime tax bills by converting at least some of the funds to a Roth IRA. Conversions are taxable, but Roths don’t have required minimum distributions and future withdrawals from Roths can be tax free. Conversions can affect other aspects of your retirement, such as Medicare premiums, so you’ll want sound tax advice before moving forward. You also may want to consult a fee-only financial planner who can review your overall financial situation and help you shape your retirement income plan.

Q&A: Required withdrawals could change Social Security taxation

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Dear Liz: Is it true that when you start your required minimum distributions from 401(k) and 403(b) plans, you give up your monthly Social Security payment? I plan to start RMDs next year at age 71 thinking I will get less money for more years.

Answer: Your withdrawals from retirement plans won’t reduce your Social Security directly. The additional income could, however, make more of your Social Security payment taxable.

Taxes on Social Security are based on something called “combined income,” which is your adjusted gross income plus any nontaxable interest you earned plus half of your Social Security income. If you’re single and your combined income is between $25,000 and $34,000, then up to half of your Social Security payment may be taxable. If combined income is over $34,000, up to 85% may be taxable. For people who are married filing jointly, the bracket for up to 50% taxation is $32,000 and $44,000 while combined income over $44,000 can trigger up to 85% taxation.

To be clear, this does not mean that 50% or more of your benefit goes to taxes. It means that 50% or more of your benefit may be subject to your income tax bracket.

Q&A: How to reduce the tax penalty from an IRA distribution goof

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Dear Liz: I have missed three years of required minimum distributions from one of my IRAs although I have not heard from the IRS about this. What do you advise me to do now?

Answer: Did you include this account when calculating your required minimum distribution each year? If so, you won’t owe a penalty. You’re supposed to calculate RMDs for each of your IRAs, but you don’t have to withdraw money from each account. Instead, you can take the year total from any of your IRA accounts.

If you forgot to include this account in your calculations, however, then you would typically owe a penalty.

In the past, people who failed to take their RMDs faced a 50% penalty on the amount they should have withdrawn but didn’t. Starting in 2023, the penalty has been reduced to 25%, or 10% if the oversight is corrected within two years of the RMD’s due date, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting.

You can request a complete waiver of the penalty if you can show the failure was due to reasonable cause and that you are taking steps to correct the oversight, Luscombe said. You’ll need to file Form 5329 and attach a letter explaining why you failed to withdraw the proper amount.

No earned income? No IRA contribution

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Dear Liz: In recent columns you’ve been discussing mandatory withdrawals from IRAs. Since these minimum required distributions are treated as income for tax purposes, can I use that money as the income necessary to make an IRA contribution this year? I am retired and lucky enough not to need the funds for current expenses.

Answer: Sorry. You need earned income, not just income, to make IRA contributions. For the purposes of an IRA, earned income includes wages, salaries, commissions, self-employment income, alimony and separate maintenance and nontaxable combat pay. It does not include earnings and profits from property or income from interest, dividends, pensions, annuities, deferred compensation plans or required minimum distributions from IRAs.

Should you roll an IRA into a 401(k)?

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Dear Liz: I have one comment in response to the reader who wondered whether she had to take minimum distributions from an IRA at age 70 1/2 even though she was still working. As you pointed out, she can defer taking minimum distributions from a 401(k), but she must take them from her IRA. I would point out that many 401(k) plans permit transfers from IRAs. Once the IRA becomes part of the employer plan, the transferred assets are no longer subject to required minimum distributions, as long as the employee continues working full time. This may be a viable option for someone who wants to delay or reduce the size of a mandatory IRA withdrawal.

Answer: Many people are familiar with the idea of rolling a 401(k) balance into an IRA when they leave a job. They may not realize they can roll money the other way as well if an employer permits it.

There are still several issues to consider before you transfer IRA money into a 401(k), said Mark Luscombe, principal analyst for CCH Tax & Accounting North America.

First, the rollover may not include any non-deductible contributions to the IRA. If the money in the IRA came entirely from tax-deductible contributions or from a 401(k) rollover, this won’t be a problem. If you made non-deductible contributions, they wouldn’t be eligible for transfer into a 401(k), Luscombe said.

“All of the sums rolled into the 401(k) plans must be funds subject to tax and not sums representing basis in the IRA,” Luscombe said. “If non-deductible contributions were made, only the taxable portion of the IRA may be rolled into the 401(k) plan.”

Another issue is that 401(k)s typically offer fewer investment choices than IRAs. Also, compare the fees with what you’re paying with your IRA. Some 401(k)s are run efficiently and give workers access to extremely inexpensive institutional funds, for example, while others lard on various account fees.

A final issue is that you’re likely to have less access to the funds in your 401(k) than you would with an IRA, Luscombe said, should you need to tap the cash. Many plans allow only hardship withdrawals from 401(k)s, although you may be able to access up to half of your funds with a retirement plan loan. Of course, if your intention is to delay required minimum distributions as long as possible and you won’t need the money, this point may not be a deal breaker.

IRA distribution could go into Roth

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Dear Liz: You recently answered a reader who wondered whether he could delay mandatory distributions from his traditional IRA because he was still working. You said correctly that he could delay taking required minimum distributions from a 401(k) but not an IRA. But as long as the questioner is working full time and meets the other tests, he could contribute to a Roth IRA. That would allow him to re-invest part or all of the required distribution. Tax would have to be paid on the distribution, but the money could continue to be invested in an account that isn’t taxed on the earnings annually.

Answer: That’s an excellent point. Withdrawals from IRAs, SEPs, SIMPLE IRAs and SARSEPS typically must begin after age 701/2. The required minimum distribution each year is calculated by dividing the IRA account balance as of Dec. 31 of the prior year by the applicable distribution period or life expectancy. (Tables for calculating these figures can be found in Appendix C of IRS Publication 590, Individual Retirement Arrangements.)

Anyone who has earned income, however, may still contribute to a Roth IRA even after mandatory withdrawals have begun, as long as he or she doesn’t earn too much. (The ability to contribute to a Roth begins to phase out once modified adjusted gross income exceeds $112,000 for singles and $178,000 for married couples.) There are no required minimum distribution rules for Roth IRAs during the owner’s lifetime. As you noted, the contributor still has to pay tax on the withdrawal, but in a Roth IRA it could continue to grow tax free.