Let’s talk about those “required minimum distributions” (RMDs) that the IRS makes retirees take from their traditional TSPs or IRAs.
- Can they bump you up into a higher tax bracket?
- If so, what can you do about it?
At Christy Capital Management, we help federal employees plan for a better retirement. One of our primary areas of focus is tax planning. We want you to pay what you owe, but we also want to make sure you don’t pay more than is required. That is often the case when you just “let taxes happen.”
Carla’s TSP-RMD-IRS scenario
Most federal employees have money in a traditional TSP. The IRS eventually requires them to withdraw that money. When they do, those distributions are viewed as taxable income, and that can impact an individual’s tax situation.
Take Carla for example. She has $1.2 million in her TSP. (Well done, Carla!) She just turned 59 1/2 years old. She doesn’t have to start taking RMDs until age 75…which means her TSP money still has 15+ years to grow. If she doesn’t do any tax planning between now and then, what type of required minimum distributions could she be looking at?
The chart below shows Carla’s projected retirement income (from various sources including Social Security). It assumes a conservative growth rate of about 5.5%.
Carla plans to retire in 2027. By law, she will have to start taking RMDs (represented by the green vertical bars) in 2040.
You can see Carla’s changing income over the years. You can also see the current tax brackets depicted by the five colored lines that sweep from left to right across the chart.
The lowest (blue) line shows the income limits of the 12% tax bracket. The green line just above it (see the red arrow) shows the income limits of the 22% bracket. The purple line above that reflects the top of the 24% bracket.
For her first two years of retirement, Carla will be in the 12% tax bracket. But from 2029 through 2039 she will find herself (just barely) into the 22% bracket.
Then comes the year 2040. This is when Carla will have to start taking RMDs (again, depicted by those rather large green vertical bars). When that RMD money is added to her Social Security income and FERS pension, you can see that Carla is suddenly in the 24% tax bracket.
Consider too, that over time, the money in Carla’s TSP will continue to grow. This means her RMDs will only get bigger. And of course, the more taxable income she has, the more she will have to pay in taxes. Notice that in 2050, and again in 2053-2055, Carla will find herself in the 32% tax bracket!
As a general rule, we could say it this way, “When RMDs kick in, your taxable income can increase substantially, presenting you with a serious tax problem.”
How Carla can mitigate potential RMD tax problems
Let’s look at how Carla might fix this RMD tax problem. One way is to utilize her current tax bracket more efficiently. Carla could do Roth conversions in whatever dollar amount gets her to the upper limits of her 22% bracket. (Remember, a Roth conversion involves taking money from your traditional TSP, paying taxes on that income, then putting the balance of that withdrawal into a tax-free Roth account.)
You can see (i.e., the yellow bars in the chart above ) how Roth conversions (starting in 2027) up to the income limits of the 22% bracket, would make Carla’s RMDs (the green bars, beginning in 2040) much smaller.
This strategy could produce an estimated tax savings of $124,000. But notice this will also push—just barely—Carla into the 24% bracket.
In short, while maxing out the 22% tax bracket helps her, it doesn’t fully fix her problem. This still shows a higher income in her 80s and 90s. What if tax rates get worse over time? That higher income would be subject to those higher taxes. This strategy doesn’t help her as much as another strategy could.
Option 2: What if Carla immediately started doing Roth conversions up to the maximum income limits of the 24% bracket? Here you can see the yellow bars get a lot higher.
And notice this too…by converting more of her money to Roth right away, Carla will have it all done by 2038. Meaning that, in 2040, when RMDs would normally kick in, there won’t be any. That’s because by then Carla will have converted all her taxable TSP funds to Roth.
From 2039 on, Carla will remain comfortably in the bottom of the 22% bracket. She won’t have to fear the prospect of future RMDs pushing her up into the 24% (or even 32%) tax bracket.
Another thing to consider is that since Carla converted all her TSP money, she isn’t accumulating a bunch of money in the qualified bucket. This is money she might otherwise have in a CD or money market account at her bank, where she gets taxed on the growth year after year. (NOTE: RMDs always mean taxation. And unless you spend that money, you’ll hold it in a taxable account.)
By using this second strategy and converting all her TSP money to Roth ASAP, Carla won’t be forced one day to take required minimum distributions and she won’t have to worry about her RMD funds accumulating in some other taxable account. A more proactive Roth conversion plan like this could save Carla an estimated $256,000 in taxes over time!
Finally, consider this: Without employing this more aggressive strategy, Carla, at age 94, would have $3.4 million of taxable TSP money, $900,000 of Roth funds, and another $2 million of taxable qualified money.
But by Roth converting all her TSP funds before RMDs kick in–94 year-old Carla would have zero taxable money and zero taxable qualified money.
The total value of her assets would be slightly less, but remember, not all money is the same. $6.33 million in Roth money is $6.33 million tax-free. Every dollar would belong to Carla. She wouldn’t owe the IRS a penny on that money.
On the other hand, by not fully utilizing this Roth conversion strategy, Carla would end up with $3.4 million in taxable account, plus another $2 million in qualified funds, which are also taxable.
Clearly, these two potential outcomes aren’t even close to being equal. With Roth, Carla has much more money in her pocket.
In both of these scenarios, Carla is paying taxes when she does the Roth conversion. The more she Roth converts, the more she is paying in taxes right then. The name of the game should not be how to pay less tax this year, but instead how to pay less taxes over her lifetime. This is an example where paying the taxes sooner will save Carla money in the long run. And if taxes get worse over time, then she will save even more.
What about you?
Hopefully, you see now how RMDs from your TSP can greatly alter your tax situation (and not in a good way).
The fix is found in doing a bit of proactive tax planning. Should you start taking advantage of Roth conversions? Perhaps, but first you’ll need to figure out how much makes sense for your unique situation. How do you “max out” either your existing tax bracket or another of your choosing? How do you make sure you’re doing as much as you can, but not too much? Financial finesse is critical.
You don’t want to Roth convert too much TSP money, too quickly and inadvertently push yourself up into a tax bracket that was too high for your needs. You also don’t want to mess up by not converting enough.
We saw in Carla’s situation that the long-term tax savings from a series of 22% conversions could amount to $124,000. However, a willingness to utilize the 24% tax bracket could potentially save her $256,00.
Understanding all the variables is critical, and this is where an experienced advisor, working with your CPA, can prove to be so valuable.
If you’ll be under the age of 59 1/2 when you retire, and you want to start doing conversions but you don’t know how to pay the taxes without being penalized, check out this video [need link].
And if all this talk of TSPs, RMDs, and the IRS, makes your heart beat just a little faster, please reach out. In the top right corner of our website’s home page, christycapital.com, you’ll see a green TALK WITH AN ADVISOR button. Click it, and leave us a short message. We’ll be in touch right away.
At Christy Capital Management, we help you take the mystery out of retirement. (That includes the confusion of taxes in retirement).
