There’s a significant benefit in using a traditional IRA account or a 401(k) plan to help save money back for your retirement. And what, pray tell, is that benefit you ask? Well, for starters, some of the money you contribute to these accounts will be hands off for the IRS, which means they are tax exempt. Who doesn’t like getting out of paying Uncle Sam their hard earned cash? Anytime I can legally avoid being taxed — through exemptions, not the financial path laid down by Al Capone — I will take that offer. More money does not, as the Notorious BIG once said, mean more problems. It often means less problems, but hey, it was still a cool song back in the day.
However, the main issue with planting your funds for retirement in a traditional plan like the ones mentioned is that you have required minimal distributions — RMDs — you have to deal with at some point down the road. RMDs are calculated every year based on your retirement plan balance and your life expectancy.
Wait. Why are you looking at me like that? You know, with that confused look on your face. The one you where you tilt your head to the left like a cocker spaniel and scrunch your eyebrows up until they come together and look like a giant caterpillar.
Okay, allow me to explain.
Each year, you will be forced to pull out a portion of your traditional IRA or 401(k) each year or you’ll get smacked with a penalty.
Better?
Cool.
Typically, the first RMD is due by the first of April the year following your 73rd birthday. After that they will be due every year on Dec. 31.
Here’s more on this from The Motley Fool:
Now for some people, RMDs aren’t really a problem because they need to remove funds from their savings anyway to cover their bills. But let’s say you’re forced to take a $10,000 RMD when you don’t need the money. Well, you just created a $10,000 tax liability for yourself — meaning, the IRS gets to tax that $10,000 as income.
But that’s not the only pitfall you might encounter if your retirement plan requires RMDs. Here are two other issues that could arise.
The first is that RMDs could cause benefits you receive from Social Security to be taxed.
Listen, I don’t care what anyone says, taxes are bad, mmmkay? So if we can avoid being taxed — again, legally, I’m not advocating not paying taxes you actually owe — you should take that route.
If your only source of income is Social Security, then you might not have the benefit taxed by the IRS. However, if you’re single and your combined or provisional income, that is, 50 percent of your annual SSI benefit added to your adjusted gross income and non-taxable interest income — is over $25,000, well, I have some bad news. You will probably have your SSI taxed. This is also true if you’re married and the combined income you have is over $32,000.
Now, let’s say you’re single with a $32,000 annual Social Security benefit. Half of that is $16,000, which is below the $25,000 threshold at which taxes on Social Security apply. However, if you’re forced to take a $10,000 RMD, your provisional or combined income is bumped up to $26,000. That puts you in the category where you face taxes on your Social Security benefits.
The second thing that could go horribly wrong is that RMDs could potentially cause the cost of your Medicare premiums to go up.
The current monthly standard premium for the Medicare Part B program is sitting at $174.70 a month. That can change year-to-year.
But if you’re a higher earner, you could face a surcharge on your Part B premiums known as an income-related monthly adjustment amount, or IRMAA. IRMAAs are based on income from two years prior. But if an RMD bumps up your income, then you pay end up paying a lot more for Part B.
Worse yet, IRMAAs apply to Part D drug plans, too. Now with Part D, there’s no standard monthly premium like there is for Part B, since costs vary by plan. But you risk a surcharge as a higher earner, and an RMD might cause you to become one.
Okay, so how do you avoid these dastardly RMDs?
You can avoid the hassles and financial misery by choosing to invest and save for your retirement using Roth IRA or Roth 401(k) instead of the traditional kind.
“Roth 401(k)s used to impose RMDs, but that rule no longer exists. And unlike Roth IRAs, there are no income limits associated with Roth 401(k)s, making them a great choice for savers whose employer plan offers that option,” the Motley Fool article states.
“Meanwhile, if you’re already in retirement and have stuck with a traditional savings plan, make sure to read up on the different ways RMDs might impact your finances. You may also want to sit down with an accountant or financial advisor to discuss strategies to minimize the negative hit RMDs might result in for you,” the report says in conclusion.