Why Corporate Executives Need to Plan Around RMDs Now

When we’re in our 20s and 30s, we were used to hearing people say, “Save now for retirement before it’s too late.” But many times, we think that retirement is too far off into the future to worry about today. The same can be said about Required Minimum Distributions (“RMDs”) while you’re in your 40s and 50s. Realistically, most people won’t have to worry too much about RMDs being ‘too big’ in the future. But corporate executives who save a lot of money in pre-tax 401(k)s and IRAs may find that future RMDs are large. This creates an unnecessary tax liability. This article deals with why corporate executives need to plan around RMDs now and strategies for minimizing RMD taxes.

Key Takeaways:

• Required Minimum Distributions are an unavoidable reality of having pre-tax retirement accounts, such as a pre-tax 401(k) or Traditional IRA.
• Corporate executives save aggressively into pre-tax 401(k)s, which creates large accounts subject to high RMDs in retirement.
• Money to cover day-to-day expenses in retirement can come from Social Security, pensions, and withdrawals from retirement accounts. 
• High RMDs can force you to take more out of your retirement accounts than you need to live on, creating unnecessary tax liability.
• Roth Conversion strategies can help control your lifetime tax liability by recognizing taxes at lower rates. This will reducing the size of future RMDs at higher tax rates.
• Executives within 10 years of retirement are encouraged to get help planning for their transition into retirement. This way, they don’t miss out on important tax-saving opportunities.

What Are Required Minimum Distributions?

Before diving in, let’s first make sure we understand the purpose of RMDs. Required Minimum Distributions are required (no pun intended) by law. It forces savers to take money out of their pre-tax retirement savings accounts and pay income taxes on the amount withdrawn. While that sounds like a raw deal, the logic makes sense when we put ourselves in the shoes of Uncle Sam.

This graphic shows us the differences between “Pre-tax” 401(k)s and Traditional IRAs and “After-tax” Roth 401(k)s and Roth IRAs. You’ll notice that RMDs are required for pre-tax accounts but not after-tax Roth accounts. Here’s Uncle Sam’s logic behind that.

• “Okay, pre-tax 401(k) saver. I’ll give you a tax credit today on what you contribute to your account, so you enjoy lower taxes today. But I’ll want to get taxes from you in the future when you take money out. To make sure you take money out, I’m imposing Required Minimum Distributions!”
• “Hello, after-tax Roth saver. I thank you for dutifully paying me income tax this year. Since you already paid me taxes on money you’ve put into your Roth account, I won’t insist on being paid taxes when you take money out. No Required Minimum Distributions for you!”

RMDs, we can see, are nothing more than a way for the government to have you pay tax on money you haven’t paid taxes on yet. But let’s note that whether you save into a pre-tax account or Roth account, you’re paying taxes on money going in or out, regardless of which one you choose.

Why do Corporate Executives Need to Plan Around RMDs Now?

Corporate executives are in the prime of their careers in their 50s. RMDs, however, aren’t required until you’re in your mid-70s. So why do executives need to worry about RMDs 20 years before they’re going to happen?

The corporate executive clients we work with are diligent savers. If they’re in their 50s, this means maxing out their 401(k) savings. This could exceed $30,000 per year with catch-up contributions. And since they’re in their prime income years, it often makes sense to make those 401(k) contributions on a pre-tax basis to help offset a portion of the high income taxes they’re paying.

The combined impact of maxing out 401(k) contributions and investment growth over many years can lead to very large pre-tax 401(k) balances. Values of $1,000,000 to $2,000,000+ balances are not uncommon. This sets the executive up for a nice retirement but also sets them up for very high RMDs.

RMDs, remember, are “required.” They’re not based on whether the person taking the RMD needs the money to fund living expenses. An executive’s pre-tax 401(k) balance might be very high. Which may lead to RMDs far above what they need to live on, which also leads to large tax bills.

To see the “problem” with high RMDs, we will look at the hypothetical case of John & Jane Sample.

Case Study for How RMDs Can Impact Corporate Executives

We show our sample client’s key facts below. This is a typical profile of the corporate executive clients we work with as they near retirement age. 

Using this information, we can project their future cash flow. On the income side, they will receive a Social Security benefit, which amounts to $90,000. On the expense side, they will have expenses of $144,000 plus some taxes. The “gap” between their income and expenses is funded from withdrawals from their investment account and 401(k)s. We can see how their cash flow progresses into the future.

For the first 10 years of retirement, John and Jane rely on Social Security income (blue bars). They might additionally withdrawal from their investment account and 401(k)s (yellow bars). This income is used to meet their annual living expenses and taxes (red line). In the years before they have to take RMDs, they can “size” their annual account withdrawals. They calculate whatever they need beyond Social Security to cover expenses. In other words, Social Security income + account withdrawals = total expenses.

But look what happens in 2035 when both John and Jane turn Age 75 and need to take Required Minimum Distributions, represented by the dark orange bars. The amount of those RMDs is well over their total expense needs. Worse, Uncle Sam’s RMD rules force retirees to take out incrementally more of their accounts each year as they get older. At Age 75, retirees have to take out 4.1% of their account to fulfill RMDs. But by Age 90 that increases to 8.2% of their account value!

How Can RMDs Lead to Higher Income Taxes?

Our sample client’s retirement plan ends up working just fine in this scenario. But they’re likely paying more taxes than they need to over their lifetime. To get a sense of this extra tax burden, we can look at their cash flow at Age 75, the first year of RMDs.

Prior to RMDs, John and Jane needed to take money out of their accounts to meet their living expense needs. Social Security income alone wasn’t enough to cover expenses. But once RMDs started, it flipped the script. Suddenly, instead of needing to take money out of their accounts they were being forced to do so by Uncle Sam. The RMD results in John and Jane receiving $107,000 more than they need to live on.

It might not seem like a big deal to get more money than you need. But we have to remember the income taxes that are paid on RMDs. Suppose John & Jane find themselves in the 25% tax bracket at Age 75. We can calculate how much “excess” tax they’re having to pay because of too much RMDs.

No one likes to pay more tax than they have to. But we see clearly in this case that retired executives can face this actual reality. It’s bad enough that John and Jane are paying $26,750 more in tax on RMDs they don’t even need to live on. What’s worse is these RMD amounts go up year-after-year. This means the ‘unnecessary’ taxes paid also go up every year for the rest of their lives.

How Can Roth Conversions Reduce Future RMD Taxes?

Knowing the facts about how RMDs work and how corporate executives might find themselves in the (un)enviable position of having “too high” RMDs. So, what can they do about it? We will now tackle our original question, “Why do Corporate Executives Need to Plan Around RMDs Now?” 

Comprehensive financial planning becomes very important for corporate executives, particularly those within 10 years of retirement. It takes years of planning to help manage future RMD levels. 

We did a two-part video series on Roth Conversions in retirement [Save Taxes By Doing Roth Conversions] and [Retirement Roth Conversions Part 2]. I won’t go through all the details. But here is my summary of the concept so you can see how they can reduce future RMD amounts.

Let’s continue with our example of John & Jane. We can project future taxable income and what tax bracket they may be in. The caveat with this analysis is that tax laws can change. But “knowing what we know today,” we can help this client create a plan to reduce future excess RMDs.

One thing we notice is that for the first 10 years of their retirement, taxable income is very low. Low enough such that they wouldn’t be paying much in the way of taxes during those years. However, by 2035 when RMDs start, we can see a steep rise in their taxable income. This will push them into the 25% and 28% brackets.

This dynamic gives John and Jane an opportunity. They can strategically do Roth Conversions during their first 10 years of retirement to “fill up” some low tax brackets. This will cause them to pay income tax on the amount converted, but they’ll be doing so in the 10% or 15% tax bracket.

The funds that are converted to Roth will never be taxed again. Nor will they be subject to RMDs. This is one strategy we use to help executives control the size of their future RMDs.

When Should Corporate Executives Start Planning for Retirement?

RMDs are just one example of the complex financial planning topics executives deal with. Other examples are deferred compensation, stock-based compensation, and paying for healthcare in early retirement. We believe the best time for corporate executives to start planning their retirement around these benefits is within 10 years of retirement, if not earlier. 

For John and Jane, we’d likely advise them early on to save into a taxable investment account, above and beyond what they save into their 401(k)s. The reason for saving into a taxable account is that they can access these funds without worrying about paying income taxes. Yes, there would likely be capital gains taxes to deal with, but those are lower than income tax rates.

Having a “stockpile” of investments in a taxable account would benefit them in several ways:

• They would have money to live on in the years after retirement but before Social Security benefits start.
• If the client retires before Medicare eligibility at Age 65, money in their taxable investment account could pay for health insurance premiums.
• They could cover the cost of income taxes resulting from a Roth Conversion strategy that’s designed to lower future RMDs.

In short, corporate executives within 10 years of retirement face the double-whammy issue of having more complex compensation details while working AND the need to plan for their transition into retirement. This is one of the most important transitions in one’s life. But there are lots of opportunities to optimize their taxes and finances. 

Next Steps for Corporate Executive RMDs

At Financial Design Studio, we wade through these complex topics like these to coordinate different strategies every day. Our job is to help corporate executive confidently transition to retiree. You should never have to worry if you are doing enough. If you want a team of professionals, who actually care, to help you prepare for retirement, why not get started and see if we are a fit? We would love to bring confidence to your finances!