Required minimum distributions are not required this year...should you CARE(S)?

By Jeff Bernier

Are you aware of the changes to the retirement plan required minimum distribution rules contained in the CARES Act? Do you have questions on whether to delay your distribution for this year?

Many of the financial decisions we make are a balancing act. This can be especially true when we try to balance income needs, tax planning, and charitable giving goals. In addition, we are working in an environment of incomplete information. We can’t know the future in terms of tax law changes, investment results, and our future needs. (Healthcare costs alone are a huge unknown.) We may also lack clarity on how to be good stewards or how to use our resources to help others in terms of our charitable giving strategies. We can make educated guesses about the future but my 34 years’ of experience reminds me to be humble. Although we use a research-based approach to planning and we think in terms of probabilities, there are just so many things that we cannot know.

What we can know are tax laws as they exist today, current asset prices, and we can take the time to evaluate a charitable giving strategy. All of these, of course, are likely to change over time. This balancing act has become relevant to many of our clients recently. We serve many families who are in the “second half”, no longer working for a paycheck, and are required to take distributions from their retirement accounts. As such, we are getting a lot of questions about the advisability of skipping the distribution for 2020.

Individuals with tax deferred retirement accounts must begin taking distributions annually based on their life expectancy at either age 70 ½ (for those born before July 1, 1949) or at age 72 (for those born after June 30, 1949). People who fail to do so could face a 50% penalty on the amount they should have withdrawn.

On March 27th, the Coronavirus Aid, Relief, and Economic Security Act (CARES) Act was signed into law. Among many of the provisions, the act includes a waiver of required minimum distributions (RMDs) for 2020. This waiver applies to company savings plans and IRAs, including both traditional and Roth IRAs.

Additionally, those who took their RMD after February 1st (and before May 15th) of this year can roll it back into the IRA or other qualified plan and avoid paying taxes on the distribution. As this is just an extension of the normal rollover rules, non-spousal beneficiaries of inherited IRAs are not allowed to roll a distribution back into the plan (though they still have the option of suspending payments for the balance of 2020). It also means that this is not an option if you have completed another “rollover” in the last 365 days as you are only allowed one per year.

For those that decide to roll the distribution back, in order to avoid taxes, they will need to replace the entire distribution even if federal and state income taxes were withheld. For instance, if someone had a $20,000 RMD and $16,000 was deposited in their account and $4,000 was withheld for taxes, the full $20,000 would need to be rolled back in to avoid taxes. If this is the case, the amount withheld is prepayment of 2020 tax liability and may be refunded when the return is filed in early 2021. Alternatively, if they make estimated tax payments or have other sources of withholding, they could adjust these amounts.

To make things even more interesting, the SECURE Act (Setting Every Community Up for Retirement Enhancement – who comes up with these names anyway?) went into effect January 1 of this year. One of the most important provisions is the loss of the ability to “stretch” distributions from retirement accounts for most non-spousal beneficiaries. You can learn more about the SECURE ACT here.

The question we are often getting from clients is: “should I stop RMDs for 2020 or rollover distributions already taken?”

This is where the balancing act comes in. While every individual should evaluate their own personal situation and every situation is unique, here are some of the things I think about when evaluating the decision:

If you don’t need the income from the account to meet expenses, it generally makes little sense to take the RMD this year and accelerate the taxes. One potential exception to this is if future year RMDs are likely to throw you into a higher tax bracket, leveling the distributions and continuing to take them this year at a lower bracket could still be advisable. If you need the distributions to meet current living expenses, you would, of course, continue to take your RMD. If you have other non-retirement accounts that could be used to fund your living expenses, you might consider using these funds and skipping the RMD, however.

If you skip the RMD this year, does this create headroom to do a Roth IRA conversion? Replacing your RMD with a Roth conversion can have several potential benefits:

• You may be able to move traditional (pre-tax) retirement accounts to a tax-free environment at favorable tax rates.
• Roth IRAs are not subject to the RMD rules; therefore, your RMD requirement in the future could be lower.
• A Roth IRA’s tax-free distributions can be used in the future to manage tax brackets (in conjunction with other taxable income sources such as RMDs, pensions, Social Security)
• As the financial markets have entered bear market territory, you may be converting shares to a tax-free environment at a lower tax cost.
• At your death, your non-spousal beneficiaries will benefit from up to ten years of tax-free growth and tax-free distributions. The taxes you pay today on the conversion can be viewed as an effective gift to the next generation.
• If you are concerned about the impact of government debt and believe your taxes will be higher in the future, converting at today’s rates could be advantageous.

It is important to remember that Roth conversions can no longer be “undone” though re-characterizations. Therefore, one should weigh completing the conversion now (when we know investment values) against doing it later in the year when you have more information on your tax situation (another balance to strike).

It is also important to remember, anytime someone over age 65 evaluates strategies to increase income (even at low tax brackets), you should review the impact earnings have on Medicare Part B premiums. If your modified adjusted gross income is above a certain amount, you may pay an Income Related Monthly Adjustment Amount (IRMAA).

Many of our clients are charitably inclined. Since the Tax Cuts and Jobs Act of 2017 expanded the standard deduction, many no longer itemize deductions. Therefore, bunching of charitable gifts and using Qualified Charitable Distributions (QCD) have become standard planning strategies. By using all or a portion of the required minimum distribution for charitable gifts, you can reduce taxable income from the RMD and still get the full standard deduction ($26,100 if over 65). Even if you skip your RMD this year, you are still allowed to make a QCD if you are so inclined. This is still an effective way to give to charity as you are giving away funds that will ultimately be taxed at higher ordinary income rates when withdrawn. Additionally, you are removing funds from the IRA which may reduce your RMDs in the future. Keep in mind, however, it will not provide any tax savings today (it will not be deductible) unless you take RMDs.

As it relates to charitable giving, another balance to strike is how to maximize tax savings, your charity’s needs for funds today, and your philosophy around giving. I believe that we are called to give regardless of tax benefits. However, I think a strong case could be made that if I am able to reduce taxes, it frees up even more capital to support causes that are important to me. Candidly, I struggle with this a bit. Would it be better to skip the 2020 RMD, not do a Qualified Charitable Distribution this year, and double the QCD next year (assuming it was under the $100,000 limit) when the reduction in income would be more valuable? I think this is an opportunity to speak with the organizations that you support and understand what their needs are today and in the future. You know, some decisions should be based on the heart and not just the head.

Another alternative to be considered would be to make significant gifts outside the IRA (ideally with low basis securities) such that you exceed the standard deduction and couple it  with a Roth conversion as previously discussed so that the charitable gifts offset income from the Roth conversion. If you did not want to give the funds to charities all in one year, you could manage your giving with a Donor Advised Fund. You can read more in our blog post Do you give to charity? Here’s how to make every dollar count under the new tax law and listen to the Tax-advantaged gifting strategies episode on the Money and Meaning Show.

One final opportunity to consider is the 0% capital gains tax rate for taxable income under $80,000 for married filing jointly. Does skipping the RMD give room under this income threshold to capture capital gains at 0% tax in taxable accounts? Here the analysis is a bit more complicated. Is it better to use this headroom to raise the basis of your portfolio (providing tax benefits in the future), provide income using these lower basis shares with no tax, or filling the headroom with a Roth conversion? While there are many factors to consider, even though current tax liability will be higher, a Roth conversion may be more advantageous. One of my educated guesses is that even if tax rates are higher in the future, there is still likely to be a differential between capital gains rates and ordinary income rates.  If this remains the case, I would rather have less in traditional qualified accounts (by moving to Roth) and more in non-qualified accounts even if at lower income tax basis.

As with all things tax related, review your strategies with your tax and financial professionals.  As I am sure this commentary makes clear, the decision to stop or rollover the RMD is not one size fits all.

We cannot control how the COVID-19 pandemic will play out. We cannot control the economic impact of the interventions we have undertaken as a country. We cannot control the investment markets. However, it does feel good psychologically to exert control over those things we can control. The planning around required minimum distributions, Roth IRAs, charitable giving, and tax management in our portfolios are decisions that can have a long-term impact.  If we can assist you in evaluating these complex choices, please reach out.

PS: Click here for a copy of our latest Key Financial Data Worksheet for 2020.