Be the Early Bird: Sometimes It Makes Sense to Withdraw IRA Funds Sooner

Most of our clients who read this blogpost title are thinking, “Where is Danielle, and what have you done with her?”

Before I answer that question, let’s go over a few terms you need to keep in mind while reading this blogpost:

Pre Tax Savings: Retirement accounts like Traditional 401ks and IRAs where contributions (deposits) were not taxed by the IRS. Instead, taxes are assessed on future withdrawals.
SS: Short hand for Social Security Income
Roth IRAs: Retirement accounts where the contributions are taxed before they are deposited. Those deposits and their earnings, if all rules are followed, are tax free upon withdrawal.
Taxable Brokerage Accounts: Nonretirement accounts like bank checking, savings, and brokerage accounts that allow post-tax deposits and are taxed only on the earnings in the year in which they are received.

For a more in-depth discussion, please review our previous blogpost Traditional Retirement Savings: Why Tax-Deferred Accounts like 401(k)s May Be the Wrong Choice for Some Taxpayers — Propel Financial Advisors.

Propel Hates Spending Retirement Funds

If you know me at all, I am firm about the importance of saving money for the future and leaving it alone. At least twice a month, a client calls, texts or emails me about invading their hard-earned retirement portfolio to pay off their house, buy a car, or put their child through college. Almost every single time, I emphatically tell them to leave it alone for the following reasons:

Tax Consequences: IRA Distributions are taxed as if you earned the money, meaning it’s added to your taxable income. A saver is usually paying 22-30+ percent in taxes to remove those funds. If that saver is under the age of 59 ½, they are paying a 10% penalty on top of that. If the saver also lives in a state that taxes retirement distributions, there will be more tax to pay. Let’s assume an IRA distribution will be taxed at 30% for Sam Saver. If he wants $20,000, he will have to withdraw $28,571 to cover the taxes. The cost of interest on your home or student loan is well under that. Just don’t do it.
Lost Earnings: All that money that was saved stops losing income. Most of us rely on the growth of our savings to support our older selves. Therefore, the cash must be invested to grow over time. When a saver removes the funds, that growth stops.
Save During the Income-Producing Years: If you think life is expensive now when you are earning money, imagine how much harder it will be when you’re not. Savers can live decades beyond their last day of employment. It is essential that the savings be ready for that period when there is no earned income at all.
College Spending: As a parent, I completely understand the desire to take care of your children and pay for their college educations. However, if your retirement savings is lacking, I strongly encourage you to rethink it. Your child has a lot of choices and many years ahead of them. Community college, scholarships, part-time jobs, and student loans are all avenues for any hard-working child whose parents can’t or won’t pay for school. Your child is not required to support you when you’re no longer working. Take care of yourself first, so that you are not a potential burden on them or on society when the time comes.

Required Minimum Distributions

The above is absolutely true during the Savings Phase. But after decades of working and saving, it is finally time to live off your retirement portfolio. But when and how do you do it?

The answer to that question is very different for each individual, but there is one constant: required minimum distributions (RMDs). RMDs are a legal requirement for all traditional 401k and IRA owners. Prior to 2020, a retiree was required to begin taking a calculated amount of money from the total 401k/IRA pool beginning in the year that the retiree reached the age of 70 ½.

Beginning with the SECURE ACT, effective 1/1/2020, that RMD age was raised to 72. Under the new provisions that are expected to pass before the end of this year, that age is expected to be raised even higher.

How does a Simple RMD work?

Sarah Saver turns 72 years of age in 2022. She is required to take her first RMD no later than April of 2023. She chooses to take it in 2022, so she will not have to take two separate RMDs in 2023.

The value of Sarah’s IRA on December 31, 2021, was $500,000. According to the IRS Uniform Lifetime Table III, the Distribution Period factor for age 72 is 27.4. The factor increases (technical point: actually the factor decreases each year, so that the resulting RMD increases each year) each year, resulting in a larger RMD each year.)

$500,000 divided by 27.4 = $18,248.18

Sarah rounds up to $18,250 and withdraws her RMD for 2022, which is reported as income on her 2022 tax return.

Sarah also receives $24,000 per year in Social Security Income. Under the tax code, half of Sarah’s SS income will be taxable. Therefore, Sarah’s total taxable income for 2022 will be $18,250 + $12,000 = $30,250. She pays federal tax of $1661.

What If Sarah’s Situation is Not So Simple?

In our example with Sarah above, we assumed she could live on her gross income of $42,250 (SS + RMD). What if Sarah requires at least $5000 net per month in income instead?

Let’s assume Sarah withdraws $40,000 per year from her IRA instead of the minimum. Now 85% of her Social Security income is taxable in the amount of $20,400. Her taxable income has now jumped from $30,250 in our previous example to $50,400. She pays federal tax of $5671. Her net is $4861 per month, which is less than the $5000 she needs. She will need to withdraw more, and she has no other savings with more tax-friendly consequences.

Now imagine that Sarah lives to be 90. Do you think her IRA will be able to sustain her for 18 years with increasing withdrawals and subsequent taxes?

Pretax Savings Look Very Different Going in Than Coming Out

While some retirees were applauding Congress’ SECURE ACT for the whopping 1 ½ additional years before RMDs were required, Propel advisors knew that this just meant larger tax bills later.

When a saver or an employer contributes to a pretax IRA or 401k, no income taxes are paid on that amount. It sounds wonderful until you calculate the amount of earnings that accumulate from that contribution year until distribution. With a simple annual income rate of 5%, a $1000 contribution will be worth $4322 in 30 years. In a pretax retirement account like an IRA, that will be taxable income on a retiree’s tax return someday.

While we have no problem with pre-tax savings and think it often makes sense, one can never lose sight of the cliff that’s coming. IRA distributions result in taxes during non-earning years. The pot of money saved begins to dwindle much faster than one realizes when no contributions are coming in, money is going out, and earnings are going down because of smaller principal.

Be an Early Bird: Don’t Wait for Your RMD

Many future retirees have most of their eggs in the pretax nest. For decades, it has been the primary source of retirement savings. Even if you have other accounts like Roth IRAs or taxable savings, you may still want to consider routine distributions from your pretax accounts to lessen future tax consequences. How do you do it?

While you MUST begin distributions from your IRA/401k at age 72, you CAN take distributions without penalty much sooner. To be clear, we are not advocating unnecessary spending. Instead, you simply take those distributions, pay the taxes, and make deposits to other types of accounts to continue investing.

Age 59 ½: Once a saver reaches the age of 59 ½, the 10% penalty on distributions from your pretax savings no longer applies. Then the funds can be used in other types of investments.
Series of Substantial Equal Payments Exception: This is a tactic which will allow a saver to tap into the IRA before age 59 ½ without triggering a penalty. It is a complex technique and will not be for everyone, but it is an option, particularly for a saver with a very large IRA during years of modest income.
Roth Conversions: A saver can move funds from an IRA to a Roth IRA at any time, as long as the taxes can be paid from earnings and not from the IRA itself.

Other tax-friendly options if one is spending money anyway:

Qualified Higher Education Expenses: For a saver with a very large IRA, paying higher education expenses for a loved one will allow you to distribute funds without penalty.
Qualified Charitable Deduction (QCD): If RMDs have already begun and the saver is giving to charity, distributions sent directly from the IRA to the charity are NOT TAXABLE.

Why We like Roth IRAs and Taxable Accounts for Retirement Distributions

When a distribution is made from an IRA, taxes on future earnings stop. When those funds are deposited instead to a Roth IRA, the funds grow tax-free. Future distributions, if all rules are met, are completely tax-free.

When the IRA distribution is deposited into a taxable brokerage account, only the dividends and interest are taxed each year as well as any realized capital gains (the difference between what was paid for an asset and its sale price). It is possible to control these taxes to an extent.

*Speak with your tax advisor about what makes sense for your individual situation on an annual basis.

Propel Loves Planning

In short, there is never one right answer for all savers, and there are a lot of options available. Recently, I gave a presentation to a group of savers. One attendee came up to me afterwards and said that she attended a free dinner where “an advisor” recommended that everyone convert all IRAs to Roth IRAs immediately. While we advocate Roth conversions, we would never make such a statement. We consider it unethical and impractical.

Our advice is to be proactive and work with a trusted advisor who can navigate these complexities with an individual’s situation in mind.