How I Learned to Stop Worrying and Defuse the RMD Bomb

Time for a quick pause in my bigger Withdrawal Strategies series – there’s a few detailed topics we need to get to before we can get to Part 3, combining when you get access to accounts with how to minimize your taxes and get to your money. Before Part 3 will make sense, I’m going to cover 3 more specific topics:

  • Required Minimum Distributions from Traditional IRA, 401(k), etc. and how to manage them (this post)
  • UK Pension withdrawal options and the Lifetime Allowance
  • RMD vs Lifetime Allowance Horse Race – how to deal with both of these at the same time

After that, we’ll get back to the Withdrawal Strategy series.

If you haven’t read my post on Roth Conversions, start there first. This post builds on that.

Why you should care about RMDs

Required Minimum Distributions (RMDs) are withdrawals that the IRS requires you to take from your Traditional balances once you turn 72. If you don’t plan for them, they’ll wind up as UK wage income, probably taxed at 20% or even 40%+. If you do plan for them, you can get a big chunk tax free, and probably any remainder at 10% or 12%. Plus, the same strategy that helps manage RMDs can help you access your Traditional money before age 59.5, aiding your early retirement.

RMDs apply to Traditional IRA, 401(k), 403(b), TSP, etc., but critically not to Roth IRAs. They technically apply to Roth 401(k), but that be rolled over to a Roth IRA with no taxes or penalties once you leave that employer – do that when you can.

Part of the challenge with RMDs is that, at least for the first few years, they increase more slowly than typical investment growth rate assumptions (increasing around 4-5% a year), but then they keep going up, so you’re now taking a larger percentage of a larger pot. They’re fixed percentages set by the IRS – you take the same percent at age 72 whether your balance is $10,000 or $10,000,000. A few graphs to illustrate:

You can see RMDs increasing exponentially every year until they plateau at over half your Traditional balance from age 115 – if you’ve made it that far and still have a Traditional balance worth mentioning, you’ve won!

For those of us that don’t live that long, you’ve still got around a 25% chance of making it to your mid-90s, if you’ve already made it to 65. It’s how RMDs behave early on that’s part of the problem:

If you assume something like 7% growth, your Traditional balance will keep increasing (on average) until about age 100, despite your RMDs – so your RMDs keep increasing both because the % required to withdraw goes up and because your pot keeps getting bigger. By the time RMDs outstrip annual growth, you’re either dead, or your pot has had another 30ish years to grow, albeit dragged by the RMDs.

So what, you’re thinking? A bunch of theoretical percentages – let’s put some £ signs on there in an example.

Assumptions: 7% growth, Personal Allowance is filled by Social Security and/or State Pension

At your peak, you’re paying £25k+ a year in UK income taxes, and if you only need something like £36k a year to spend, you’re still getting more than £60k a year after taxes – uncontrolled income that you don’t necessarily want. Now, this isn’t the end of the world, since you’ve basically got plenty of money to spend in retirement, more than you want or need. That’s not exactly the worst problem to have. But here’s the thing – you could get exactly the same money out of your Traditional accounts, but without paying any taxes, or at least staying within the 20% bracket or lower. Let’s look at the options for managing these RMDs.

RMD Management Options

You’ve got three main options for dealing with RMDs:

Option 1: Take the RMDs

  • Take the RMDs from age 72 and pay any taxes due – this isn’t a bad option if your Traditional balance isn’t too high and your Social Security & State Pension aren’t too high.
    • In many typical cases, just Social Security and State Pension will fill up your £12,570 Personal Allowance.
      • Since RMDs, Social Security, and State Pension are all UK taxable as wages, and UK wage tax rates are higher than US ones, it’s the UK allowance we really care about – and remember, you don’t get to combine with a spouse, whatever comes out of your account counts against your Personal Allowance.
    • That pushes all your RMDs into the 20% basic rate tax bracket. If your Traditional balance at age 72 is over £500k ($700k) or so, you can get into the 40% higher rate bracket later in retirement.
    • I don’t want to pay 20% or 40% if I can avoid it – so, we need option 2.

Option 2: Withdrawals from 59.5

  • Traditional withdrawals, from age 59.5: You only have max 10 years where this really helps (age 59.5 when you can start to access the Traditional balance to age 67-70 when you start getting Social Security & State Pension), and at £12,570 a year, that’s “only” about £125k before you pay tax, and don’t forget that you’ll still be getting x% growth on the invested balance.
    • With a 7% real growth rate, you can get about an £80k ($112k) balance at age 59.5 to zero by age 68 without paying tax. Anything bigger than this, and you’ll have RMDs at 72, likely taxed at 20%.
    • You could plan to take more than the Personal Allowance to accelerate this, but you’ll pay at least 20% tax or higher at withdrawal.
    • Or, you can tackle the problem earlier and at a lower tax rate with…

Option 3: Roth Conversions

  • Roth conversions reduce your Traditional balance and manage the taxes. I recommend you start as early as possible, if you go down this route – at retirement or even semi-retirement.
    • As soon as your wage income is below the US standard deduction ($24,800 if you’re sharing with your spouse), you can convert Traditional to Roth, tax free. It’s taxed as wages, so keep your total wages (if any) + Roth conversions under the standard deduction.
    • After 5 years, you can also withdraw the Roth conversions as Roth contributions – tax free. Helpful if you’ve retired well before 59.5.
    • If you have a large Traditional balance, you may even want to convert more than the Standard Deduction – you’ll pay US tax on this, but you can keep it to 10 or 12% under $81,050 total (be careful of how this impacts your capital gains tax rate, though, if you’re also withdrawing from taxable investments or a S&S ISA). That compares favorably to UK tax on the RMDs at 20% or more, and then you get to invest the remainder tax-free forever. Very roughly, you’d want to start thinking about intentionally paying US tax at the starting values in the table below.
Retirement Age303540455055
Danger Traditional Balance at Retirement (MFJ Standard Deduction, $24,800)$330k$325k$310k$295k$270k$240k
Danger Traditional Balance at Retirement (single Standard Deduction, $12,400)$165k$160k$155k$145k$135k$120k
Danger Traditional Balance at Retirement (UK personal allowance, £12,570)£165k£160k£155k£145k£135k£120k
Assumptions: constant 7% real growth, target of zero Traditional balance at age 72. At starting balances above the values in the table, you’ll need to go above the Standard Deduction in order to get to zero. Values are rounded to be conservative, so you can start thinking, even if you don’t take action.

To illustrate this point a bit more, here’s the value of a £100 (or $100) investment growing at 7%/year in both scenarios: paying 10% tax at age 50 and never paying tax again, or paying 20% tax on withdrawal (at age 72 here):

Paying 10% tax now will always beat paying 20% later, at any growth rate. Even if you get into the 12% US tax bracket, that still beats paying 20%. If filling the 12% bracket still isn’t enough to get your RMDs to zero, you’re going to want to look at the possibility of using the 22% US bracket on Roth conversions vs the concern of RMDs getting into the 40% UK bracket. This becomes a concern around a Traditional balance of £600k at age 72, very roughly – if you’re at $750k or so age 50, you’ll struggle to get down to £600k by 72 without getting into the 12% bracket (assuming $1.4 to the £ – adjust as needed if the exchange rate drifts too far).

Big Caveat: I think Roth conversions are UK tax free, although I’m not 100% sure. Even if you think they’re UK taxable, you could convert up to the Personal Allowance (£12,570) without paying UK tax. In early retirement, unless you’re still working part time, you don’t have anything else in your wages tax bucket, so fill it with Roth conversions. Because of the lower Personal Allowance compared to a joint Standard Deduction, you can’t reduce as large of a balance – see the last row of the table above. There’s not a lot of point in exceeding the Personal Allowance – you’re picking between paying 20% now or 20% later on the RMDs, so it’s a tossup unless you think tax rates will change, or if you’re worried about getting above the 20% bracket on RMDs.

Of course, if you’re married and both partners have a Traditional balance, you can both do Roth conversions and fill each of your Personal Allowances. Be careful of exceeding the US Standard Deduction in this case; maybe you could use carried over Foreign Tax Credits to exceed it without paying tax (gets a bit complicated – I haven’t worked this one out in detail).

Comparing the Options

I’ll get into more details on some scenarios in Part 4 of the Withdrawal Strategies series, but just as a quick comparison, let’s look at four examples. All of them have a couple retiring at age 50 with £900,000 of savings, £300,000 of which is in a Traditional 401(k). They both live to age 94. There are other assumptions, but they’re pretty middle of the road and they’re all the same for each scenario – I’m just trying to show the magnitude of the difference the different strategies can make.

#RMD StrategyRMD @ 72RMD @94Total Tax Paid in Retirement
1No 401(k) withdrawals until RMDs start at age 72£31k£59k£311k
2a401(k) withdrawals up to a single Personal Allowance from age 59.5£23k£45k£213k
2b401(k) withdrawals starting at age 59.5, high enough to reach a zero balance at age 72£0£0£113k
3Roth Conversions from age 52, 401(k) withdrawals at 59.5 to reach a zero balance at age 72£0£0£28k
I’m also ignoring any Lifetime Allowance excesses in a UK Pension/SIPP – more on that in an upcoming post.

A little help from asset allocation

One more thing – you might also consider where you hold the various parts of your asset allocation, moving the bond part into your Traditional balances where possible. This has three advantages:

  1. Bonds tend to grow more slowly (but steadily) than stocks, so your future RMDs grow more slowly the more bonds you have in a Traditional account – move that growth to somewhere that doesn’t have RMDs.
  2. Bond income in a taxable account would be taxed as interest as it arises, at the higher wage tax rates, although with a healthy tax-free allowance in the UK. So you’re better off with bonds in a tax-deferred account anyway, paying the income/interest rates there, and leaving stocks in your taxable account, paying only the lower capital gains and dividends rates.
  3. Keeping bonds out of your tax-free accounts in favor of equities should allow them to grow more, without paying tax.

This applies from today, not just in retirement – if you allow your Traditional balances to grow less over the decades, you don’t need to manage them as aggressively in retirement. Based on this, I’m going to revisit my asset allocation – I won’t change the 10% target in bonds, but I may move my bonds from my Roth IRA into my TSP (similar to a 401(k), and subject to RMDs). Shouldn’t affect total returns across my portfolio, but helps reduce the size of the RMD problem.

10 thoughts on “How I Learned to Stop Worrying and Defuse the RMD Bomb

  1. I think you have the danger of RMDs spot-on, but I think all employer and personal DC pensions face the same problem. If you end up in the enviable position of having sizeable DC assets by the time you reach state pension age, you could face some serious tax bills. There’s no point getting (mostly) basic rate tax relief on contributions only to get hit with higher rate on drawdown. The biggest drawback to early withdrawal of UK pension assets is that they then become potentially subject to IHT. Also, there’s no point taking the money out and then just sticking it in a cash savings account. You should either spend it (sustainably) or reinvest it in ISAs or taxable accounts. Of course that then means more work, because you no longer have the safety of holding PFICs in a pension.., If I could wave a magic wand and change just one tax regulation, it would be to reclassify UCITS funds as non-PFIC to UK/EU-resident retail individuals. But even that “simple” change I don’t see happening.

    Liked by 1 person

    1. I’m working on a similar post about UK pensions – seems like the aim is the same (get some tax paid before the owner dies), but the Lifetime Allowance is a very different way of achieving that aim. That’s what I’m trying to figure out, how do you optimise between the two of them. On one hand, RMDs can get out of hand without proactive management, and once they start there’s nothing much you can do to turn off the tap, plus they affect the entire balance. On the other hand, lifetime allowance is just a straight 25%ish hit on anything over the limit – reading through all the different Benefit Crystallisation Events is complicated , but it adds up to taking that 25% hit sometime before or when you hit 75. But, it’s only on quite large balances, and only on the amount over the allowance – if you’ve got £1.1M in a pension, you only get hit on that small part above the allowance.

      And then you add in the different levels of tax relief – if you’re a basic rate payer who saves for a long time and gets over the lifetime allowance, that 25% hit plus your income tax is pretty painful. If you’re in that lovely 62% bracket from £100k-£125k, it makes sense to put as much in the pension as possible and take the hit. 42-47%, tougher to say.

      And fully agree on the PFIC regulation – it’s one of those cases where a very broad brush approach was taken to fix a small problem. Sure, I get the US not wanting people stashing money away offshore to evade taxes, but penalizing retail investors in boring index funds was not the intent. Same with the KID issue – there’s no good reason to prevent EU/UK investors from buying US index funds that are practically identical to offerings in the EU, but can be held in US-based accounts for Americans in the EU/UK.

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