Change in RBD Increases Importance of Tax Diversification

With the stroke of the president’s pen on December 29, 2022, the SECURE 2.0 Act became law. This legislation includes many provisions that are directed at retirement plan sponsors and individual retirement account investors—primarily encouraging more retirement savings, offering more after-tax savings options, and delaying taxation on tax-deferred savings.

For individual investors, the ability to defer tax on retirement savings provides the benefit of saving more money today and potentially paying less tax on every dollar later when you need it in retirement. Employer retirement plans (401(k)s, 403(b) plans, etc.) and individual retirement accounts (IRAs, SEP IRAs, etc.) are tax-deferred retirement accounts that offer this benefit.

Required Beginning Date (RBD) Extended

The IRS makes it clear—you cannot keep retirement funds in your account indefinitely. The RBD is the age at which you must begin taking money out of your retirement accounts. The amount investors are required to take out of their retirement accounts upon reaching the RBD is called the required minimum distribution (RMD). That amount is calculated using the account balance at December 31 of the prior year and a life expectancy factor based on the investor’s age.

Effective with the SECURE 2.0 Act, as of January 1, 2023, once you turn 73 you must start making your RMDs. Then, starting January 1, 2033, the RBD is extended again to age 75.

For many investors, this is a great opportunity to remain invested for a longer period and experience several more years of potential tax-deferred appreciation. Investors are given a longer time horizon for tax-deferred growth with the extension of the RBD, but a larger retirement account comes with additional planning considerations.

RBD Extension Planning Considerations

If the traditional technique for retirement account distributions is to delay as long as possible, the SECURE 2.0 Act may lead to changes in conventional thinking. With distributions from retirement accounts taxed as ordinary income, it becomes more important following this change to prepare for increased taxable income and take a more tax-efficient approach toward retirement account distributions. Here are several considerations:

Consider saving into taxable or Roth after-tax accounts – Tax diversification—investing in accounts that have various types of tax treatment—offers distinct benefits to investors who will have larger compounding retirement accounts. Start saving into a taxable or Roth after-tax account in addition to retirement accounts. Having accounts that are not taxed as ordinary income when distributed will provide flexibility to manage taxable income during retirement.
Consider performing Roth conversions before RMDs – Converting some of the tax-deferred money in retirement accounts to Roth after-tax accounts can reduce the impact of RMDs. Performing Roth conversions generates taxable income today but can provide income flexibility in the future and gives investors control over the amount taxed today.
Manage taxable income to help mitigate Medicare costs and income-related monthly adjustment amount (IRMAA) surcharge – The Social Security Administration applies a surcharge in addition to its Medicare Part B and Part D premiums for people with taxable income over certain limits. Consider using taxable accounts or implementing Roth conversions earlier in retirement to help manage taxable income and mitigate IRMAA surcharges.
Consider using qualified charitable distributions – This strategy reduces retirement account balances by making gifts directly to charity. The distributions are not considered taxable income and satisfy the RMD requirement. You must be age 70 1/2 or older to use this strategy.

Summary of the RBD Extension’s Impact

Overall, the provisions in the SECURE 2.0 Act directed toward retirement accounts and investors are a positive development for retirement savings and readiness. Delaying RMDs gives investors the opportunity for tax-deferred savings to compound longer and grow larger, which is a good thing for many retirees. However, there also is a need to plan for more tax-efficient distribution strategies to avoid too much tax deferral when RMDs finally arrive. Having taxable accounts, Roth after-tax accounts, and tax-deferred retirement accounts provides investors flexibility to draw income from different sources, may extend the life of your portfolio, and allows for better management of income tax rates.

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