There are plenty of good reasons to save for retirement in a traditional IRA or 401(k) plan. These plans allow you to contribute money tax-free, so your IRS burden is eased during your working years. IRAs and 401(k)s also let your money grow tax-free. In fact, taxes only come into play once you start taking withdrawals as a senior.
But there's one drawback to traditional retirement plans -- they impose required minimum distributions, or RMDs. And not only do RMDs impact your general taxes, but they could also make it so your Social Security benefits are subject to taxes as well.
An age-old rule could impact your benefits
RMDs have been around for a long time, though the age at which they kick in recently changed for the better. It used to be that RMDs came into play starting at age 70 1/2, but now, you don't have to worry about them until you turn 72.
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The amount of your RMD will vary based on your life expectancy and retirement plan balance. But there's a steep penalty for not taking one -- you'll lose 50% of each dollar you fail to remove from your retirement account. In other words, if your RMD for a given year is $10,000 and you take none of it, you'll forgo $5,000.
Of course, the problem with RMDs is that they automatically create a tax liability when taken from a traditional IRA or 401(k) since the money you withdraw will be subject to taxes. But that's not the only damage RMDs can cause. If your RMD is high enough, it could push you over the limit where your Social Security benefits become taxable at the federal level.
Whether Social Security gets taxed depends on your provisional income, which is 50% of your annual benefit plus your non-Social Security income. If your total falls between $25,000 and $34,000 as a single tax-filer, you could be taxed on up to 50% of your benefits, and beyond $34,000, you risk taxes on 85% of your benefits.
These thresholds are higher for married couples filing jointly. A provisional income between $32,000 and $44,000 could mean taxes on up to 50% of benefits, and beyond $44,000, 85% of benefits.
Now, let's say you're single and collect $18,500 a year from Social Security. That alone puts you well below the threshold for having that income taxed. But let's say you've also amassed a nice egg and that your first RMD equals $16,000. That puts your provisional income at $25,250 ($16,000 + $9,250), which means you're bumped into that category where you can be taxed on your benefits.
How to avoid RMDs
RMDs are a problem for many seniors, especially when they create a tax situation on the Social Security front. If you'd rather avoid RMDs, the solution is simple -- house your retirement savings in a Roth IRA.
A Roth IRA is the only tax-advantaged retirement plan that doesn't impose RMDs, so it'll give you a lot of flexibility during your senior years. If you don't need to touch your savings for many years, you can leave that money alone, keep it invested, and watch it grow. And once you do want that money, you can withdraw it tax-free.
Of course, with a Roth IRA, you won't get the same up-front tax break as you would with a traditional retirement plan since contributions are made with after-tax dollars. But if you want to avoid a tax headache later in life, a Roth IRA is a smart choice. That way, you'll keep more of your senior income away from the IRS -- including the Social Security benefits you've earned.
