New required minimum distribution rules: What plan sponsors need to know

Wealthy retirees seem to have scored big in Congress’ sweeping year-end spending package, SECURE 2.0.

The new legislation includes changes to retirement plans that will push up the age people are required to start withdrawing from their IRAs and 401(k)s to 73 next year from the current 72, and extend it to 75 in 2033.

That’s a boon to those who don’t need the money (retirement behemoth Vanguard estimates some 25% of its clients don’t take money from retirement accounts until they’re forced), because every additional year allows those investments to continue growing tax-free.

But just because investors can delay doesn’t mean they should. If they’re fortunate enough to not need the money in their retirement accounts for living expenses, they should still weigh the implications for their taxes, heirs and Medicare premiums before they decide to wait until the deadline.

How much the Internal Revenue Service requires you to take out each year is based on account balances and age. Holding off will likely result in bigger required withdrawals and potentially heftier tax hits when investors do finally start taking money out. (If they have a 401(k), they need to know what their own plan requires, as employers may have different guidelines for distribution.)

For instance, the IRS would require a 72-year-old with a $1 million retirement plan to take a distribution of about $36,500 in 2022. Delaying the withdrawal would allow that money to stay invested and grow. But that likely means a higher account balance in future years and fewer years to spread it over — thus the minimum distribution required later would be higher.

And since those distributions are considered income, they’ll affect how much individuals pay in Medicare premiums, potentially cranking up insurance costs each year.

Under changes made in 2019, non-spousal beneficiaries — meaning children who are over the age of 18 — who inherit retirement accounts have to empty them within 10 years after the original accountholder dies (for deaths after 2019).

“It’s ‘The Great Tax Crunch,’” says Jeff Levine, a certified public accountant and financial planner at Buckingham Wealth Partners. “Fewer years of forced distributions plus fewer years of possible distributions means there is the potential for a lot more income to be squeezed into a lot smaller number of years.”

The issue merits a careful look. There had been some confusion since the 2019 change about whether beneficiaries must take regular distributions in each of the 10 years after the accountholder’s death, or just be sure to drain it within the 10-year window. The IRS proposed rules in February that mandated annual withdrawals by heirs if the original owner had died after the required start date for distributions.

Related: IRS to fix inherited IRA guidance that confused advisors

Given the confusion, the agency said it won’t begin issuing penalties until 2023 for heirs who fail to take annual withdrawals under the new rule. And now, thanks to changes in the current year-end bill, punishments have been eased. Amounts not withdrawn as required will be subject to a 25% tax — half what it was before — and as little as 10% if the withdrawal is made soon enough.

If delaying distributions still seems like the way to go, wealthy savers may be able to use the extra time they’re given to convert some of an IRA to a Roth IRA, says Ed Slott, a certified public accountant who specializes in IRAs.

With a Roth IRA, taxes are paid upfront and investors enjoy tax-free withdrawals after the age of 59 and 1/2, as long as the money has been in the account for at least five years. Converting to a Roth IRA is often best-suited for those in their early 70s when income is relatively low (so the tax rate applied to the conversion amount is lower) and required minimum distributions haven’t yet started (to avoid having to pay taxes on the distribution at the same time you’re paying taxes on a conversion.)

With Roth IRAs, accountholders aren’t subject to required minimum distributions for that money, so it can continue growing for their heirs. A Roth IRA is generally more advantageous for heirs, too, because they don’t have to pay taxes on withdrawals if the money has been in the account for five years.

So, yes, the new government spending package holds some potential advantages for wealthy retirees, but they don’t come without potential trade-offs. Advisors need o to educate investors to think it through from all the angles, which will help them make the decision that’s best for them.

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