Imagine that you’re forced to take income this year. For some of you, it’s not just in your imagination. Many high earners and retirees find themselves in situations where they are forced to take income. This can be due to inherited IRAs, reaching the age for Required Minimum Distributions or deferred compensation payouts. While having additional income sounds great, it often leads to unintended tax consequences.
This is often a question of control and timing that can cause challenges. Let’s talk about how these situations arise and some strategies to consider to help you preserve more of your income.
Required Minimum Distributions
Recently, the most common place that we see issues arise is with Required Minimum Distributions or RMDs. RMDs are the amounts that are required to be distributed from qualified retirement plans (employer-sponsored plans such as 401k or 403b plan) or Traditional IRA accounts each year. Generally, RMDs begin when you have reached a specified age, currently 73 years old but the required age will increase to 75 years old in 2033. However, those who have inherited IRAs are also often subject to RMDs. The amount of the RMD is calculated annually and is dependent upon your age (or potentially the age of the decedent in the case of an inherited IRA) and the balance in the account.
Quite often, the account owner does not need or want the income in the current year. However, the penalty associated with a missed or insufficient distribution can be large. So, let’s discuss some options to lessen the tax impact of required distributions.
Qualified Charitable Distributions
A Qualified Charitable Distribution (QCD) is a donation made directly from an IRA account to a qualified charity. The amount contributed can count towards the RMD for the year and avoid income taxes at the same time. However, there are quite a few requirements that you’ll have to meet to get the full benefit of this strategy. And, this strategy requires some upfront planning because there are timing elements. Read our article about Qualified Chartiable Distributions and how the strategy can help you manage your taxes and your insurance premiums.
Other RMDs – Take larger distributions
Another way to reduce future unexpectedly large RMDs is to reduce the balance in your IRAs and qualified retirement plans. One way to do this is to take larger distributions in lower-income years. This allows you to take the income when you will be subject to a lower income tax rate, hopefully reducing the overall tax impact over time. Also, remember that your RMD is your minimum required distribution. You can take more than the minimum whenever you want, and this may be advisable in low-income years.
Roth Conversions
Or, consider executing Roth conversions. A Roth conversion involves distributing dollars from your pre-tax IRA or pre-tax qualified plan directly to a Roth account. Taxes will be due on the amount you convert in the year that you convert. But, these conversions reduce the balance in your IRA or pre-tax qualified plan, the amount used to calculate your future RMDs. The Roth conversion allows you to take control of the timing of your income for tax purposes; you can choose to do these conversions in lower-income years. The further benefits are that qualified distributions from your Roth IRA are not subject to federal income tax (they aren’t even reported on your tax return), the growth that occurs after the conversion won’t be taxed and RMDs don’t apply to Roth accounts. You don’t need to have wages or earned income to be eligible for a Roth conversion. Read more in our article on Roth conversions.
Contribute to a retirement account
There’s an additional option if you’re eligible to contribute to an IRA or qualified retirement account. Remember that you can only deduct the IRA contribution if your income does not exceed certain thresholds. Anyone with earned income can contribute; only some people can deduct the contribution. If the intent is to reduce your tax bill, be sure to consider whether you’ll actually accomplish your goal before deciding whether and how much to contribute. And, don’t forget the long-term impact of contributing to a pre-tax employer retirement plan or Traditional IRA today. You may cause a bigger tax burden in the future when you are subject to the RMDs discussed above.
If you are the beneficiary of an inherited IRA, you may also be subject to RMDs regardless of your age (unless you’re a minor). Or, perhaps you meet the age requirement for a QCD but you’ve already taken a distribution this year. If so, read on to learn other strategies that could help lessen your tax bill.
Other forced income payments
Here are some other examples of forced income payments that can affect your taxable income:
- Forced plan distributions from a qualified plan
- Deferred compensation plan payouts
- Certain life insurance benefits
Unfortunately, there are fewer options for these payouts. This is one of the reasons that we like to maintain control of income payments as much as we can, and we recommend income planning every year. In these cases, examine the areas where you may have control.
Timing of bonuses or other income
Are you able to defer a bonus or other income to a future time? Spreading out the income may mean that you can reduce the effective tax rate for this year without significantly affecting the tax rate in one or more future years. This includes contributions to pre-tax retirement accounts if they’re available to you. But, you may be robbing Peter to pay Paul here. Deferring income to a future period may be exactly the past strategy that is causing your current challenge. It’s important to look at the overall effect of the strategy, not just the effect on this year.
Consider these deductions to reduce taxable income
If you itemize your deductions, consider charitable donations. As discussed above, relatively few people itemize deductions. But if it does apply to you and you are charitably minded, you can evaluate the impact of accelerating your charitable contributions. In fact, even if you don’t normally itemize deductions, perhaps accelerating or “bunching” your donations into a single year (consider a Donor Advised Fund), may allow you to itemize deductions and take advantage of a charitable contribution deduction for the current year.
Net Operating Losses
If you are a business owner, remember that Net Operating Losses (business losses) can often be deducted against personal income – up to a limit. But, keep in mind, these need to be losses due to actual business expenses – not capital losses. You should consider the timing of business expenses in the context of your larger financial picture.
What doesn’t work?
It’s important to note that taking large capital losses in your portfolio generally won’t help you here. Certainly, reducing the amount of gain you take in the year that you have additional income will help lower your Adjusted Gross Income. But, when it comes to losses that exceed your gains, you can only take a capital loss deduction of $3,000 if you’re Single or Married Filing Jointly or $1500 filing Married Filing Separately against your other income. Larger losses will need to be carried forward.
Planning can help
Some of the strategies mentioned above work best in the context of a plan that covers multiple years. For instance, whether to take a distribution and the size of the distribution from your IRA or other retirement account this year, or whether to execute a Roth conversion should ideally be decided when comparing your current year’s income to the income expected in future years.
Don’t underestimate the value of annual planning. Annual income planning, determining your income needs and the sources of income you intend to tap for those needs, is also helpful. This process can help you identify the need for certain strategies like the QCD before you accidentally disqualify yourself by taking a distribution before the QCD. Or, you can be more aware of the impact of taking capital gains or losses in your portfolio when you have done some income planning for the year. And, when you do annual income planning, you may recognize a low-income year and discover opportunities to head off potential future tax challenges by taking distributions or executing roth conversions in the low-income year. Read more here about the importance of annual income planning.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.