Can you really lower taxes by skipping RMD this year? The CARES Act gave us older retirees the option of not taking our RMD this year. The IRS says something like 80% of folks must take their RMD for their living expenses. I’ll assume you are in the 20% that don’t need to take RMD for your spending: you could skip RMD and sell securities in your taxable account for your spending. This post describes when skipping RMD could really save on taxes. My basic conclusion is that the potential to save taxes applies to those who have Social Security as a significant source of their total income, and I also conclude it’s a Lot of Effort to figure out if you can save perhaps $500 in taxes. And it’s easy to flub this up.
== No? benefit if your income is “high” ==
If your income – other than RMD – is high enough, skipping RMD is not that of a much benefit. My estimate of “high enough income” is when other income – interest, dividends, other pension income, for example – exceeds you gross Social Security benefit.
As I described in this post, you are not avoiding paying a tax: you are deferring when you will record that taxable income and pay tax on it. I used to think I would always come out ahead by deferring taxable income, but that is not an obvious truth for us retirees.
The problem for us retirees is that deferring taxable income may result in more tax later. This is because the underlying math of RMD consistently pushes you toward tripwires of higher Medicare Premiums –deducted from your gross Social Security benefit – and toward the next, higher marginal tax bracket. Over a decade, it can be a mighty push. You’ve lost when you cross Medicare tripwires and cross into the next marginal tax bracket that you could otherwise avoid.
The push comes the fact that when you are in your early 80s, your RMD will likely be double your initial RMD: at average market returns your portfolio will grow substantially even though you are withdrawing RMD; and you’ll pay a much greater RMD percentage a decade from now. And if it’s two of you now and one dies, that next Medicare tripwire and marginal tax bracket will be half the distance they are now.
== The benefit is at “lower” income ==
If you have somewhat modest income other than Social Security you may save on taxes by skipping RMD this year. You can permanently avoid paying taxes that you would otherwise pay. You could keep your total Taxable Income low enough such that you are in the 0% tax bracket for capital gains taxes. Unfortunately, I calculate that the practical benefit for my example tax payer is in the range of only $500. And it ain’t easy to figure out to avoid making an error to get that $500.
== You need a spreadsheet ==
The math for your actual tax benefit isn’t straightforward. I enclose this spreadsheet for a single filer to illustrate the potential benefit. The benefit is that the Capital Gains tax rate is 0% if your total Taxable Income is less than $40,000. You may be able to sell more taxable securities this year that are taxed at 0% Capital Gains tax rate – and thereby avoid 15% tax in a future year. The complexity is because but the recorded capital gain increases the percentage of your Social Security taxed at Ordinary rates. Taxes go up. Whew!
I can only explain this by walking through an example.
Our taxpayer, Barbara, is single and 74. She will record the following income on her 2020 tax return: $30,000 gross Social Security benefit, $5,000 from a Defined Benefit Pension Plan; and she estimates $6,100 from interest and dividend distributions from her taxable mutual funds.
Barbara calculates her Safe Spending Amount (SSA) (Chapter 2, Nest Egg Care.) as $40,000 for the upcoming year. That’s the gross amount – before taxes – that she will withdraw from her nest egg this December. Barbara decides not take RMD this year. She will get the $40,000 from sale securities in her taxable investment account; I assume she records $12,000 capital gain on that sale. The result is total tax of $165 for the year. She will pay $165 tax on Ordinary income and 0% tax on the capital gain. 29% of her Social Security benefit is taxable.
(Note: Barbara’s total cash for spending that is routinely added to her checking account for the upcoming year is about $73,000 or about $6,000 per month.)
Barbara is about $22,000 below the $40,000 level of Taxable Income where capital gains are taxed at 15%. The next increments of capital gain are taxed at 0%, but each increment also increases the percentage and amount of Social Security that is Taxable Income: more capital gains at 0% tax means more taxable Social Security and Ordinary Income tax.
Let’s just assume Barbara sells more Taxable Securities, but then invests the proceeds the same day in a somewhat similar Mutual Fund. Her proceeds become the new cost basis of this mutual fund. I’ll assume the sale results in added $10,000 in capital gains income.
In a normal year – with the added ordinary income from RMD – that would all be taxed in at 15% ($1,500 tax) but it’s 0% tax this year. What is the effect on total income tax? 62% of her Social Security benefit is taxable now. Barbara pays a total of $1,200 in tax. That’s $1,035 more in tax and is effectively 10% of the added capital gains she recorded.
What’s the conclusion:
• Barbara can permanently avoid paying $500 of capital gains tax.
• This year she pays an effective capital gains tax rate of 10% not 15%. She pays $1,000 more in tax this year, but she will avoid paying $1,500 in a future year.
• The $1,000 she pays this year lowers her net from her SSA by $90 per month. Next year she will have $125 more per month.
Barbara is still a few $1000s below the $40,000 in Total Taxable Income for 0% tax on capital gains. You can play with the spreadsheet, but she has room for only about $1,000 more in capital gains. Beyond that she is paying 15% tax on the added capital gains and also driving up the percentage of Social Security benefits that is taxed: that’s not a good move. It’s easy to flub this up.
Conclusion: This post examines who can really save on taxes – totally avoid paying taxes – by not taking RMD this year. You can save if Social Security is a big portion of your income other than RMD. The benefit comes from selling more taxable securities and recording more capital gains that would be taxed at 0%. The practical benefit is less than this, since more capital gains taxed at 0% increases the percentage of Social Security benefit that is taxed. I provide a spreadsheet that a single tax payer could use to calculate the benefit. This is a bit of work – a lot of work, I think – to figure out how to save, perhaps, $500. It’s also easy to flub this up.