One of the biggest and most important positions of the bill deals with required minimum distributions (RMDs).
RMDs remain a sticking point for many retirees and are a tax bomb waiting to happen. However, with the passage of the SECURE Act 2.0, investors and their advisors may have some wiggle room and allow for some interesting planning scenarios. All in all, the new law gives investors a big break when it comes to these dreaded payouts.
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The problem is Uncle Sam won’t let you defer those taxes forever. Eventually, he wants his share. And with that, the IRS will force you to eventually withdraw money from the accounts, even if you don’t need it for retirement spending. These forced withdrawals are called required minimum distributions (RMD) and are based on age.
The amount you need to withdraw is based on your account balance at the end of the previous year and your life expectancy based on your age. That withdrawn amount is then taxed as ordinary income rates. Get the number wrong or don’t withdraw enough, and there are some stiff penalties. Forgeting to take them at all will attract the maximum level of penalties and fees.
For investors with large 401k or IRA balances, this is a potential tax bomb waiting to happen.
Starting this year (2023), the law pushes the age limits of RMDs to 73, up from the current 72. However, if you turned 72 last year or earlier, you will need to continue taking RMDs as previously scheduled. The law further pushes back RMDs as well. On January 1, 2033, the threshold age for RMDs is set to rise to 75.
The law also provides investors a break with regard to penalties associated with forgetting or not withdrawing enough funds to cover the RMD. Historically, RMD penalties were a steep 50% excise tax. So, if you were required to take out $5,000 and you didn’t, you’d owe an extra $2,500 in taxes/fees. The new SECURE Act 2.0 drops that number to just 25%.
Those penalties get reduced further to 10% if the account owner makes the correct withdrawal and submits a corrected tax return within a timely manner. Truth be told, dates and amounts for RMDs can be tricky to figure out; this gives investors some leeway to make things right.
Those investors with Roth IRAs and 401ks get an RMD break too. Even though they are not subjected to taxes on withdrawals, previous rules still required investors to withdraw funds or be subjected to the excise tax. The new SECURE Act 2.0 removes the RMD requirement completely.
Finally, those looking to annuitize a portion of their 401ks or IRAs get a break on RMDs as well. Previous rules spilt annuities into two parts and, under those rules, RMDS could be actually higher. The SECURE Act 2.0 allows you to combine distributions from both parts to satisfy RMDs’ requirements.
Because investors aren’t forced to withdraw money until later, they can benefit from additional tax-deferred compounding. Moreover, this helps eliminate sequences of withdrawal risk and reduces longevity problems. The issue is that RMDs are based on the value at year end. Finish the year higher, but start the new year in a downtrend, investors lock in losses and are required to withdraw more than their portfolio could handle.
Additionally, investors can withdraw smaller amounts of money leading up to their RMD year to reduce account balances and generate additional tax alpha. Investors may be able to pay less in taxes today and tomorrow by being smart with their withdrawal strategy rather than being forced to take out money when Uncle Sam says so.
The extended RMD age also gives investors more time to make decisions on Roth conversions, which are now not subject to RMDs. Here again, the extended time allows for planning and the potential for additional tax alpha generation.
Finally, the reduced penalties could be used as an income and gain planning tool. With penalties reduced and the ability to reduce taxes further if investors make amended RMD returns, investors can potentially time when they make their RMDs rather than being forced to do so in April/tax time. For some investors sitting on losses, those that invest in volatile high-growth stocks, or those that day trade, waiting and paying the lower fee could be advantageous if gains are greater.
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