CIO explains why smaller IRA distributions might actually increase your overall tax burden and ultimately reduce the after-tax growth potential of your wealth. (UBS)

If you inherited an IRA or 401(k) from someone who died in 2020 or later, the IRS recently announced some good news: the IRS is not assessing the penalty for missed 2021 and 2022 required minimum distributions (RMDs) for certain IRA beneficiaries who are subject to the so-called “10-year rule” (see IRS Notice 2022-53 for details). Beneficiaries who paid a penalty from missing their 2021 RMD may also request a refund of that tax.

This isn't the first time that the IRS has granted relief for families subject to RMDs. In 2009 and 2020, the IRS waived RMDs for all IRAs and employer account-based defined contribution plans. This brings us to a question that applies to much more than just inherited IRAs: Should you make IRA and 401(k) distributions faster than the IRS requires, or just do the bare minimum?

At first glance, the answer seems obvious. If you are able to skimp on your IRA distribution, it will help you to lower your taxes in the current year, and the funds that you would have sent to the IRS can continue growing in your portfolio. However, the truth is that smaller IRA distributions might actually increase your overall tax burden and ultimately reduce the after-tax growth potential of your wealth. There are two main reasons for this:

1. Delaying distributions may put you into a higher tax bracket in the future.
Once they begin, RMDs force investors to pay income on a portion of their tax-deferred retirement savings each year. While most of us bristle at government requirements—especially when the intent is to make us pay taxes—the truth is that RMDs can be beneficial for many families, helping them to spread the taxable income from retirement distributions over more years.

Without following a gradual distribution process like the RMDs, you may end up compressing your taxable income into a smaller number of years, increasing your overall tax burden. To understand why, it's important to bear in mind that there are two tax rates that are important in the US tax system:

  • The marginal tax rate is amount of tax you pay on your last dollar of income, divided by that dollar of income. As your income goes higher, your “last dollar” gets pushed into a higher tax bracket, and thus this rate goes higher.
  • The effective tax rate is the actual percentage of taxes you pay as a percentage of all of your taxable income.

For the purpose of deciding when to take an IRA distribution, the marginal tax rate is important. Taxable IRA distributions may shift you into a higher marginal bracket in a given tax year, increasing your total tax paid.

To help illustrate how this works, let's consider a simple example: you have USD 1 million of taxable income. If you were to incur USD 1 million of taxable income in a single year, this would fill up the 10%, 12%, 22%, 24%, 32%, and 35% marginal tax brackets, as well as put over USD 350,000 into the 37% marginal tax bracket. As a result, this would rack up a total tax cost of USD 304,000 (an effective tax rate of 30.4%). If you were to make annual distributions of USD 100,000 per year over the next 10 years, your total tax burden would be much lower—approximately USD 132,000 (an effective tax rate of 13.2%).

2. Delaying IRA distributions may increase the tax rate on your future portfolio growth.
If you do not need IRA distributions to fund your spending, and you can keep the assets invested, the following options would allow you to move some of your future portfolio growth from ordinary income taxation to a potentially lower tax rate:

Option A: Make a taxable distribution from your Traditional IRA

In this scenario, you pay ordinary income taxes on your deductible contributions as well as any growth. After reinvesting the distribution in a taxable account, future dividends, income, and realized capital gains will be taxed on an annual basis. The good news is that growth in your taxable account will generally be taxed at a lower rate than if you had kept the funds in your retirement account; while ordinary income tax rates go as high as 37%, the highest tax rate on long-term capital gains taxes is only 23.8% (20% plus a 3.8% net investment income tax).

Investing in a portfolio that includes municipal bonds, and implementing tax loss harvesting, can help you to further reduce the impact of the annual “tax drag.” In fact, you may be able to defer some capital gains taxes long enough for your heirs to benefit from a step-up in cost basis when you pass away (which essentially eliminates those capital gains tax obligations).

Option B: Implement a Roth conversion
A Roth conversion will trigger ordinary income taxes on your deductible contributions, as well as any growth in the account. By reinvesting the converted funds in your Roth retirement account, any future gains will be completely tax-free as long as you make qualified distributions (wait until you are age 59 1/2 or older, abide by the 5-year rule, etc.). IRAs that are inherited by a non-spouse beneficiary cannot be converted to a Roth IRA.

Read the full blog If the IRS waives your RMD, should you still make a distribution? 31 October 2022.

Main contributors: Justin Waring and Ainsley Carbone

This content is a product of the UBS Chief Investment Office.