For people over 72 with tax-deferred individual retirement accounts (IRAs), required minimum distributions (RMDs) are a part of annual income planning and tax budgeting. RMDs require the account holders (or beneficiaries, if the account is inherited) to take a distribution based on their remaining life expectancy.
The reasoning is clear: A portion of money that was once tax-deferred is now required to be recognized as current income so that the IRS can finally be paid its tax revenue. For 2020, however, this requirement has been suspended. You can breathe easy if you haven't taken your RMD yet this year and hadn't been planning to take one before Dec. 31.
A result of pandemic relief
While government-induced pandemic relief has been short-lived and limited in impact, Congress did enact legislation to suspend mandatory retirement account withdrawals in 2020 via the CARES Act. Money held in tax-deferred retirement accounts, including nondeductible IRAs, 401(k)s, 403(b)s, and inherited IRAs, is typically taxed upon withdrawal. Any withdrawal from these accounts results in taxable income in the year of distribution, which yields revenue for the IRS. RMDs force account holders to initiate annual withdrawals from these accounts once they turn 72, or immediately if the account is inherited.
By suspending the RMD requirement, lawmakers allow retirees to have a shot at a lower total tax bill for 2020. If retirees skip their RMD this year, then it will reduce their taxable income and could even potentially keep them out of higher tax brackets.
However, there's a potential catch. If you don't take an RMD this year, then your RMDs for next year and beyond will get calculated from higher year-ending balances. It's important to know where you stand with regard to your total income for any given year, and to understand that your actions during the year will ultimately dictate your tax liability the following April.
What this means for you
From a planning standpoint, 2020 is a year in which many people had lower income than expected due to unexpected job loss and other challenges related to our global health crisis. Interestingly, this could provide an opportunity to take voluntary withdrawals from tax-deferred retirement accounts. If your income was lower than expected, you could potentially withdraw money from retirement accounts up to the point at which your total income would enter a higher tax bracket.
For example -- ignoring deductions for simplicity -- if you're single, earned $50,000 in 2020, and have money in a traditional IRA, you could withdraw up to $35,525 before entering the 24% federal tax bracket. In this example, you would be able to exercise more control over your total income for the year than if the RMD suspension had not occurred.
It's well worth the time to calculate your 2020 estimated income as of today to determine if you can withdraw money from your retirement plan without inadvertently paying a higher tax rate. If you're someone with high income that's taxed well past the 24% bracket, the RMD suspension provides an opportunity to further defer taxation to future years when your total income has a chance to be lower. This might happen if you're planning to retire soon or opt for freelance work over traditional employment.
Planning for 2021 and beyond: one size does not fit all
Even though RMDs are not required for 2020, they're currently set to be required for 2021. This knowledge in and of itself should spur a longer discussion around your tax-deferred accounts and when you plan to declare the income held within. If, for example, you have a significant share of your net worth concentrated in a former employer's 401(k) plan, future distributions are going to be a large part of your retirement tax planning. If, on the other hand, most of your net worth is in taxable accounts and Roth IRAs, tax planning around RMDs becomes less of an immediate priority.
Everyone's tax situation is entirely different and will require separate analysis. Proclamations from government entities tend to have multiple public interpretations, to put it lightly. Take the time necessary to thoroughly evaluate your total tax picture and try to plan your account withdrawals according to your estimated income for each year. This will mean gathering brokerage account statements, pension and Social Security statements, and any W-2s or 1099s from employment; taking them together and in context; and drawing your tax planning decisions from there.