Securing Lower Taxes

THE TWO SECURE ACTS—2019’s and 2022’s—may inadvertently increase the federal and state tax rates on tax-deferred retirement accounts, such as 401(k)s, 403(b)s and IRAs. While well-intentioned, the laws result in required withdrawals being bunched into fewer years—which could push people into higher tax brackets. But there are ways this tax toll might be lightened or avoided, as you’ll see.

With tax-deferred accounts, the normal advice is to delay taxable distributions for as long as possible to give more time for investment growth. That rule might need to be ditched. Why? For starters, the two SECURE Acts have raised the age when required minimum distributions (RMDs) must begin—from age 70½ in 2020 to age 72 in 2022, 73 in 2023 and 75 in 2033.

Now, consider that the average lifespan of Americans fell during COVID-19. In practice, then, there might be just a decade or so of required withdrawal years before the balance goes to beneficiaries. And that could be quite a taxing event.

Widows and widowers, for example, can owe higher taxes than married couples with equivalent incomes. Widows with taxable incomes between roughly $45,000 and $90,000 would pay a 22% top marginal tax rate, versus 12% for a married couple filing a joint return showing similar income. This is the so-called “widow’s tax,” which has been well-documented on HumbleDollar and elsewhere.

Similarly, children or grandchildren who inherit might be hitting their peak earning years—and paying taxes at their highest marginal rate. Compounding the problem, 2019’s SECURE Act shortened the distribution period for inherited IRAs to 10 years for most beneficiaries. Previously, distributions could be taken over a beneficiary’s remaining actuarial lifespan—the so-called stretch IRA.

If we assume that these heirs take equal annual distributions, they’d need to withdraw roughly 10% a year, instead of the 3% to 5% per year typical under the old stretch IRA. These larger distributions could push some heirs into higher tax brackets for a decade. Admittedly, this is a nice problem to have.

Still, if you want to mitigate taxing situations like these, here are eight ideas, some of which overlap:

1. Fund Roth accounts, while also converting traditional IRAs to Roths. Because Roth money isn’t taxed again, you’d avoid higher income tax rates in later years. The benefits of Roth conversions have been broadly covered here and here.
2. Take earlier and more frequent distributions from your traditional retirement accounts. Earlier distributions could be beneficial under three circumstances—if future marginal tax rates would be higher once RMDs kick in, if federal income tax rates rise as scheduled in 2026, and if beneficiaries would be taxed at a higher rate than the current account owner, perhaps because of their fortunate inheritance.
3. Take earlier IRA distributions and invest that money in a taxable account. Subsequent gains would be taxed at lower capital gains tax rates. If held until death, the investments could receive a step-up in basis and pass income-tax-free to heirs.
4. Take earlier distributions and give the proceeds to family members or other potential heirs. Yes, you’d owe income tax on the withdrawals. But if the gifts are kept at $17,000 or less per person in 2023, there would be no gift-tax consequences.
5. Name more beneficiaries for your traditional retirement accounts, so the resulting extra taxable income would be spread among more folks.
6. Slow or stop contributions to retirement accounts if adding more money is going to result in highly taxed RMDs.
7. Use qualified charitable distributions to reduce the balance in a tax-deferred IRA. Those who have passed age 70½ can give away up to $100,000 a year from an IRA directly to charities without incurring taxes. But be careful: Money given to a donor-advised fund or private foundation doesn’t qualify for this tax exemption.
8. Bequeath your traditional retirement accounts to charity, while saving Roth and taxable account money for your heirs.

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