The Problem with Big IRAs: RMD

Most of us assume if we generate a huge IRA or 401k, we won’t have anything to worry about in retirement. While that’s mostly the case, there are a few things to think about.

The IRS loves when you build up a massive 401(k) or IRA because they get to tax you big time when you go to retire and start your RMD’s (required minimum distribution).

Not only will you pay ordinary income taxes on your IRA distributions, but you’ll also pay taxes on up to 85% of your social security benefit!

Don’t worry if this all sounds Greek to you, I’ll walk through all the details in this post. It will help if you read my primer on social security, as we’ll get into some details that I previously covered.

Also, I’ll use IRA and 401(k) interchangeably as they’ll have the same consequences. They are both tax-deferred investment accounts which you’ll pay ordinary income tax on when you use the money in retirement.

How big IRA’s can be a problem

Telling someone they’ve saved too much money into their 401(k) is kinda like telling them they’re too happy. However, there are implications that will make you less happy when tax season comes around.

The problem begins when you hit your RMD age, which was just changed to age 72 and was previously age 70 and a half. The IRS requires you to remove a minimum amount from your account each year based on a sliding scale.

The IRS requires an RMD so the taxes have to be paid on it in your lifetime. If there wasn’t an RMD, there’s a good chance many IRAs would end up inherited by the next generation and wouldn’t ever get taxed.

How is the RMD calculated?

The RMD calculation is quite simple. Start by adding up the balance of all IRAs and 401(k)’s as of December 31st the previous year. Next, reference the IRS RMD table and divide your total account balance by the distribution period given in the table.

The example below is based on the former RMD requirements at 70, so it will change based on the new RMD rule.

If you have $1,000,000 in your IRA and you’re 72 years old, your required minimum distribution is ($1,000,000 / 25.6) $39,062 at age 72, and gradually decreases as you get older. 

$39k might not sound like a huge amount if you’ve saved a million dollars in your IRA, but you’ll have to pay taxes on this after you pull your distribution.

Tax implications of the RMD

There are a couple of items to consider when calculating the impact of your IRA distribution. The first is the tax you’ll pay on your distribution. 

We don’t notice the taxes on our regular paychecks because the money is pulled out by the company, but when you write a check to the IRS for $5,000 on your distribution, you’re going to notice!

As your IRA and 401(k) accounts were tax-deferred, you’ll now pay income tax when you pull the money out, on your original investment plus all earnings. Also, unless you live in one of the nine states that don’t tax income, you’ll also pay state income tax.

We’ll get into some examples below, but this can have a huge impact on your retirement income.

Tax Impact on Social Security Benefits

The second major tax implication of your RMD is the additional tax you pay on your social security benefits. Once you start hitting certain income thresholds, up to 85% of your social security benefits can be taxed at your marginal tax rate. 

It gets a little more complicated when calculating how much tax you’ll pay on benefits as the IRS will use your “provisional income”.

Your provisional income is your Adjusted Gross Income (AGI) plus tax-exempt interest (like you’d get from municipal bonds) plus half of your social security benefits.

You pay tax on any provisional income over the tax benefit thresholds.

These thresholds aren’t very high. When your provisional income is over $34k as a single filer or $44k as a joint filer, you’ll pay taxes on 85% of your social security income above that amount. If you are under $25k in provisional income as a single filer and $32k as a joint filer, you don’t pay any taxes on your social security benefits. 

RMD and Social Security tax example

Let’s walk through a real-world example to see how impactful these tax payments can get.

Jamie is a single filer living in Utah who just turned 72 years old. She saved $1 million in her 401(k) which has since been converted to an IRA and will now start required minimum distributions.

Jamie’s social security benefits are $24,000 per year, and up until age 72, she didn’t pull additional taxable income from anywhere else, which meant she remained under the social security tax threshold.

Now that she’s reached her RMD age, here’s what she’s facing:

Income

• Social Security benefits: $24,000
• IRA RMD: $39,000
• Total income: $63,000

Provisional income calculation: $39k + $12k (half of social security) = $51k

This means Jamie will pay taxes on 85% of her social security benefits on the amount over $34k in provisional income and 50% on the amount between $25k and $34k. This would be calculated as:

• 50% threshold ($34k – $25k) = ($9k * 50%) $4,500
• 85% threshold ($51k – $34k) = ($17k * 85%) $14,450

Amount of SS benefits taxed = $18,950

Adjusted Gross Income (AGI): $39k (IRA RMD) + $18,950 (SS) = $57,950

We won’t get too deep into taxes, but let’s remove the standard deduction amount for single filer ($12,400) to calculate taxes.

Tax Calculation

• Taxable income: $57,950 – $12,400 =$45,550

Federal tax based on tax tables:

• 22% tax bracket ($6,074 AGI in this bracket) = $1,336
• 12% tax bracket ($29,776 AGI in this bracket) = $3,573
• 10% tax bracket ($9,700 AGI in this bracket) = $970

Federal income taxes: $5,879

• State income taxes (Utah = 4.95% flat of AGI) = $2,254

Total taxes = $8,133

Jamie went from paying no taxes on her social security benefit, to reaching her RMD age of 72, and now she’s paying $8,133 in taxes!

This whole time she thought she’d have an additional $39,000 per year from her IRA, but that number quickly dropped to $31,000 because of all of the additional taxes.

Each state taxes social security benefits differently, it just happens Utah uses the same formula as the federal provisional formula. Unless you’re in one of the nine states listed above, you should research how your state will tax your benefits.

Most people don’t realize the major impact RMD’s can have on their tax situation and how it can add additional taxes on your social security benefits. As for Jamie, her extra IRA RMD income is effectively cut by 20% because of taxes.

There are ways to minimize these tax impacts through different strategies I’ll write about later.

However, if you’re interested in reaching financial independence as we did, it’s good to start learning about these strategies now so you can plan accordingly.