A new law increasing the age you must withdraw from your retirement accounts may come with some unexpected and expensive consequences.
Retirement legislation President Biden inked in December pushes the age that retirees must start taking req uired minimum distributions, or RMDs, from IRAs, 401(k)s, and 403(b) plans, to 73 this year, up from 72. That will bump up higher to age 75 in 2033. The delay allows investments to grow tax-free even longer and offers a window to sock more tax-deferred dollars away.
But postponing your RMD may ultimately leave you with larger required annual withdrawals later in life, pushing your income into a higher tax bracket that may affect what you pay in taxes for Social Security or for your Medicare premiums. It could also become a tax headache for heirs.
“The more you push back on the RMD age, the shorter that window to get all of that money out becomes,” Ed Slott, a certified public accountant in New York and an expert on IRAs, told Yahoo Finance. “And as you stuff more income into a shorter time period, overall you and your beneficiaries are going to end up paying more in taxes.”
RMD rules
You can’t keep funds in a retirement plan or a traditional IRA (including SEP and SIMPLE IRAs) indefinitely. Eventually, they must be cashed out and taxed as ordinary income.
The new rule requires that once you hit 73, you have no choice but to start pulling money out with an RMD, which is calculated by dividing your tax-deferred retirement account balance as of Dec. 31 of the preceding year by a life expectancy factor that corresponds with your age in the IRS Uniform Lifetime Table. As your life expectancy declines, the percentage of your assets that must be withdrawn ramps up.
Under the new law, account holders who fail to take an RMD face a 25% penalty on the amount that is not distributed, down from 50%. And if you fix it fast, the penalty is lowered to 10%.
Tax implications
If you have other taxable income in addition to your Social Security benefits, such as your RMD, that can impact how much your benefit might be taxed.
If you file a federal tax return as an individual and your combined income — your adjusted gross income, plus nontaxable interest you have earned on investments, plus one-half of your Social Security benefits — is between $25,000 and $34,000, you may have to pay income tax on up to 50% of your benefits. If you earn more than $34,000, up to 85% of your benefits may be taxable.
For those of you who file a joint return and have a combined income between $32,000 and $44,000, you may have to pay income tax on up to 50% of your benefits. If your joint income is more than $44,000, up to 85% of your benefits may be taxable.
Moreover, if you delay taking funds out, your RMD based on your dwindling life expectancy will be larger, and if tax rates should increase, you’ll ultimately pay a bigger tax bill.
“The tradeoff is that there could potentially be higher RMDs later and guessing what future income tax rates will be is quite a large gamble. If they are higher in the future, they would be worse off than taking them earlier,” said Eileen O’Connor, a certified financial planner and co-founder of Hemington Wealth Management, told Yahoo Finance.
Slott had a similar take.
“People who don’t need the money think they’re saving something by delaying the RMD,” Slott said. “But over the long haul, they may end up paying more in tax by waiting till 73 and only taking minimum distributions.”
The potential impact on Medicare premiums
Delaying your RMD can also have repercussions on your Medicare premiums. Premiums are based on your modified adjusted gross income, or MAGI. That’s your total adjusted gross income plus tax-exempt interest.
Simply put, if you have higher income, you might wind up paying an additional premium amount for Medicare Part B and Medicare prescription drug coverage. The standard rates bump up for individuals with a MAGI above $97,000 and for married couples with a MAGI of $194,000 or more.
Heirs may also feel the sting
“The delay of the RMD can create a more difficult planning environment if heirs are involved since they need to empty inherited IRA distributions within 10 years,” O’Connor said.
The reality is that the more money you leave socked away in a retirement account for your heirs to inherit, the bigger the tax bite it may be for them. It’s likely they will inherit when they are probably in the highest tax bracket of their life during their peak earning years. As a result, they will end up paying more in taxes.
“And since the life expectancy is now 76.4, they could be leaving a lot of IRA assets to heirs,” O’Connor said.