Although most non-tax professionals don’t appreciate it, there’s a fair amount of symmetry throughout the tax law. This is especially true when it comes to retirement plan contributions.
Deductible, Nondeductible, or Partially Deductible Contributions
Employers, employees, and self-employed individuals can make deductible, nondeductible, or partially deductible contributions to retirement plans. Deductibility depends upon the type of plan.
Contributions to traditional 401(k), 403(b), and SEP-IRA plans are deductible with the exception of after-tax employee 401(k) contributions. Contributions to Roth 401(k) plans and Roth IRAs are nondeductible. Traditional IRA contributions are deductible, nondeductible, or partially deductible depending upon filing status, income level, and participation in other retirement plans. All contributions are subject to specified limits.
Age 70-1/2 – The Party’s Over
Once you turn 70-1/2, you’re no longer allowed to contribute to a traditional IRA. In addition, account owners generally must begin taking annual withdrawals from their retirement plans. Exceptions to this requirement include non-inherited Roth IRAs and 5% owners of businesses sponsoring a retirement plan. The first payment can be delayed to April 1 of the year following the year in which you turn 70-1/2.
Required minimum distributions (RMDs), is the technical term for the annual minimum amounts that must be withdrawn from retirement plans beginning at age 70-1/2. While the title of this post euphemistically refers to RMDs as “Recapture My Deductions,” the required distribution rules make no distinction between previously deductible vs. nondeductible contributions.
RMD Calculation and Taxation
RMDs are calculated by dividing the prior December 31 balance of the retirement plan or IRA account by a life expectancy factor published by the IRS in tables in Publication 590-B – Distributions from Individual Retirement Arrangements.
The life expectancy factor for RMDs for noninherited retirement plans for most people is generous, beginning at 27.4 at age 70 and decreasing gradually to 1.9 at age 115 or older. This allows individuals who only take RMDs to retain balances in their retirement plan accounts at death to transfer to their heirs.
Distributions from non-Roth accounts are fully taxable with the exception of those arising from nondeductible IRA and after-tax employee 401(k) plan contributions. A special calculation must be performed to determine the taxable portion in the latter situation.
Plan for Distributions When Making Retirement Plan Contributions
There’s symmetry between the fact that contributions to retirement plans, with the exception of non-inherited Roth IRAs, are subject to the required minimum distribution rules. What goes in, plus earnings, must eventually be withdrawn.
What most people, overlook, however, when deciding whether to make deductible vs. nondeductible contributions to retirement plans, especially 401(k)s, is the fact that cumulative distributions from retirement plans often exceed cumulative contributions. Furthermore, the difference can be significant.
When deciding between making contributions to a traditional vs. Roth 401(k) plan, most people assume that the current tax savings from making a deductible traditional 401(k) contribution will exceed any long-term benefit to be derived from nontaxable distributions from a Roth 401(k) plan. This is often untrue, even in situations where your marginal tax rate when making contributions exceeds your rate at the time of withdrawals. This is illustrated in my How to Put Some Muscle Into Your Roth 401(k) September 2, 2016 MarketWatch article.
Reduce RMDs with Roth IRA Conversions
RMDs are taxed at ordinary income tax rates. This can be as high as 37% for federal purposes plus applicable state income taxes which can be as much as 13.3% in California under current tax law.
To the extent that you do strategic or market-sensitive Roth IRA conversions, you will reduce your RMDs and eliminate taxation on the growth of your conversions. Furthermore, you can also potentially reduce taxation of your Social Security benefits and Medicare premiums.
Optimize Your After-Tax Retirement Plan Distributions
When you retire, you should optimize after-tax retirement plan distributions for you and your heirs. While you can play the game of making deductible retirement plan contributions and “recapture my deductions” beginning when you turn 70-1/2, this may not be the best strategy for accomplishing this goal.
