Required Minimum Distributions (RMD) and Healthcare costs

June 1, 2016 marked an important day in our nation that largely went unnoticed. Kathleen Casey-Kirschling, America’s first baby boomer, turned age 70?. That means that each day for the next 18 years, close to 10,000 individuals will follow in her footsteps and begin to consider when and how to take the required minimum distribution (RMD) from their qualified account. Not only are the baby boomers the largest segment of the US population but their holdings in 401(k), 403(b), 457, and IRA assets represents trillions of dollars. RMD distributions are fully taxable as ordinary income.

The intersection of taxable RMDs and retirement health care costs can create a significant impact on retirement income. Medicare Part B and Part D premiums are based on modified adjusted gross income. Higher taxable incomes create higher premiums. Since these premiums are typically deducted from one’s Social Security Benefit, the result of higher Medicare Premiums is a reduction in retirement income. 

RMDs must be taken by April 15 of the year following the year in which you turn age 70?. Medicare premiums are based on income from two years prior. This means if Kathleen takes her RMD in 2017, any potential increase in her Medicare premiums will happen in 2019.

There are a few financial planning considerations that should be considered as you approach RMD age. Each has the potential to lower the taxable RMD, protecting against slipping into a higher Medicare premium tax bracket.

?   Qualified charitable distribution. This popular strategy allows you to make a direct transfer of up to $100,000 from your IRA to an IRS approved charity. The distribution, therefore, is not taxable. The tax benefit of gifting a highly appreciated security will usually be superior to the RMD gifting, but other than that, it can be well worthwhile.

?   Qualified Longevity Annuity Contract. If you are considering ways to guard against outliving assets, especially for clients with particularly long life expectancies, a QLAC can provide a guaranteed lifetime income and a reduction in your RMD. Up to $125,000 can be transferred from the IRA into the QLAC. Under this scenario, the RMD is calculated on the smaller amount remaining in the IRA. The QLAC pays taxable income, guaranteed for life, at a future point in time.

?   Continue working. For those who continue to work beyond age 70 ? the RMD is not required from their qualified plan (such as a 401(k)). This relief is not available if you are a 5% or greater owner of a business and does not apply to anyone’s individual IRA accounts.

?   Plan ahead with the Roth IRA and 401(k). Since distributions from Roth accounts are tax-free, considering accumulating a portion of your retirement nest egg, during your working years, in these accounts. Most employers offering a traditional 401(k) make a Roth 401(k) available but very few employees take advantage of them.

 What is an RMD

You are 70? this year. Over the years, you've accumulated funds in a traditional IRA or employer-sponsored retirement plan and those funds have been growing tax deferred. But tax deferral doesn't last forever with a traditional IRA or a retirement plan. At some point, the government requires that income tax be paid on those funds, and that's where required minimum distributions come into play. Unless an exception applies, income tax is due when distributions are made.

 You know (because you've read about the required minimum distribution (RMD) rule) that you have to start taking minimum distributions from your IRA or employer plan no later than April 1 of the year after reaching age 70?. When you have to start taking distributions is known as the required beginning date (RBD). You have a choice of taking your first required distribution either (1) in the year you reach age 70? or (2) by April 1 of the following year. Although the general "rule" is to defer the payment of taxes whenever possible, deciding whether it's better to take or defer that first required distribution requires some analysis.

 Retirement plans may have a later distribution date

 There is one situation in which your first required distribution can be taken later than described above. If you work past age 70? and are still participating in your employer's retirement plan (and you do not own more than 5 percent of the company), you may delay your first distribution from that plan until April 1 following the year of your retirement. Note, however, that a plan is permitted to provide that the RBD for all employees is April 1 of the calendar year following the calendar year in which an employee reaches age 70?.

 Tip:    Each year thereafter you have to also take a minimum distribution.

 How you calculate this RMD amount is explained in detail in our separate topic discussion on the required minimum distribution rule. What is important here is when you have to start taking these required distributions.

 Calculating when minimum distributions must begin

 When do you reach age 70?? It's six calendar months after your 70th birthday. Here are a couple of examples of calculating the timing of the first required distribution.

 If you were born on June 30, 1946, your 70th birthday is June 30, 2016. You'll reach age 70? on December 30, 2016. You can either take your first distribution in 2016 (the year you reach age 70?) or delay it until the following April (April 1, 2017).

 However, if your birthday was July 1, 1946, you'll reach age 70 on July 1, 2016, and age 70? on January 1, 2017. You can take your first distribution in 2017 (the year you'll reached age 70?) or delay it until the following April 1 (April 1, 2018).

 Note that your second required distribution is required by December 31 of year two (2017 in the first example and 2018 in this last example).

 Advantage and disadvantage of speeding up or delaying the first distribution

Maybe taking minimum distributions each year isn't an issue because you're already withdrawing more than the required minimum amount each year.

But what if you don't need the money now in your IRA or plan and you want to keep your funds growing tax deferred for as long as possible? In these cases, you might be thinking that you'd wait until the last possible moment (April 1 of the year after you reach age 70? rather than in the year you reach age 70?) to take your first minimum required distribution. But that could be a mistake for a couple of reasons.

 Caution:        This discussion pertains only to traditional IRAs, not to Roth IRAs. Roth IRAs are not subject to the RMD rule while the Roth IRA owner is alive. Note, however, that the RMD rules do apply to Roth 401(k), 403(b), and 457(b) plans while you are alive.

Why the starting date matters

A distribution from a traditional IRA or retirement plan is generally taxable income in the year made. If all contributions to your IRA were deductible contributions, the entire distribution must be included in your income. If nondeductible contributions were made to the IRA, only part of the distribution is included in your income. Similarly, if after-tax contributions were made to your retirement plan account, part of the distribution is not included in your income.

Example(s):  You reach age 70? in year one and take your first required distribution in December of year one. Your distribution is included in your income for year one. If, instead, you take your first required distribution in March of year two, your distribution is included in your income for year two.

Your second RMD is due by the end of the year following the year in which you reach age 70? (the end of year two in the examples given). Unlike your first required distribution, you have no choice about the year in which you receive it. If you don't take your first required distribution by the end of the year that you reach age 70? (year one), you will actually be taking two distributions in year two. You will have to take your first required distribution by April 1 of year two and your second required distribution by December 31 of year two. So what's the big deal? Well, receiving two required distributions in the same year could push you into a higher tax bracket. Additionally, the extra income might affect the portion of your Social Security benefits that is considered taxable and could have a negative effect on deductions that are sensitive to adjusted gross income.

Example(s):  You are unmarried and reached age 70? in 2015. You had taxable income of $25,000 in 2015 and expect to have $25,000 in taxable income in 2016. You have money in a traditional IRA and determined that your RMD from the IRA for 2015 was $50,000, and that your RMD for 2016 is $50,000 as well. You took your first RMD in 2015. The $50,000 was included in your income for 2015, which increased your taxable income to $75,000. At a marginal tax rate of 25 percent, federal income tax was approximately $14,543 for 2015 (assuming no other variables). In 2016, you take your second RMD. The $50,000 will be included in your income for 2016, increasing your taxable income to $75,000 and resulting in federal income tax of approximately $14,521. Total federal income tax for 2015 and 2016 will be $29,064.

Now suppose you did not take your first RMD in 2015 but waited until 2016. In 2015, your taxable income was $25,000. At a marginal tax rate of 15 percent, your federal income tax was $3,289 for 2015. In 2016, you take both your first RMD ($50,000) and your second RMD ($50,000). These two $50,000 distributions will increase your taxable income in 2016 to $125,000, taxable at a marginal rate of 28 percent, resulting in federal income tax of approximately $28,037. Total federal income tax for 2015 and 2016 will be $31,326--almost $2,262 more than if you had taken your first RMD in 2015.

Thomas Marino is a Registered Representative with QCC. Securities offered through Questar Capital Corporation (QCC), Member FINRA/SIPC. Advisory Services offered through Questar Asset Management (QAM), A registered Investment Advisor. Atrium Financial LLC is independent of QCC and QAM. These are the views of Forefield Inc., not the named Representative nor Broker/Dealer, and should not be construed as investment advice. Neither the named Representative nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Professional for further information. Securities offered through Questar Capital Corporation (QCC), Member FINRA/SIPC. Internal Doc Number: 4100-2016