The Retirement Mistake of Letting a Big IRA Grow Untouched

If you have money in a 401k or an IRA, you have a business partner you never agreed to. He owns a piece of every dollar in there and at a certain age he starts forcing you to cash him out whether you need the money or not. Today, Phil's going to show you how big that bill gets, how it can land on your kids, and the window most people miss to shrink it. Phil, you sat across from a client recently who found out about this the hard way. What did he say to you when you told him the number?

Well, I can tell you this much. He did not have near the amount of laughter that we're having about it.

I guess not.

As I think about how clients sometimes can react, simultaneously you feel sorry for them, but at the same time, just watching the reaction that they have, it can bring a little humor.

So, how much was he being forced to take out?

Well, that's what got him so frustrated because in this case, he did not know. He had no idea that these forced distributions were going to happen. All these years he's been accumulating and doing a great job. He and his wife have done a great job. And so they've got all this money accumulated, millions of dollars, and they did not realize that forced distributions were reality. So not a little bit of a distribution. When you start talking about 120, 30, 50, $200,000 a year, plus social security, you got a lot of tax bite to worry about. And so in this case, yes, multi-million dollar IRA account kicking out some pretty significant distributions.

Does he need the money? Meaning, does he need the distribution to supplement his lifestyle? That's probably the biggest hangup for most people, is why they get frustrated with these RMDs, because they don't always need the money.

And so when that money's coming out and they can't stop it, it's like a water main break and you just have to hope someone comes along to rescue you. But in this case, Uncle Sam wants the waterline break, right? They want it. And that's because you owe them roughly a third and it's their money and they want it. So those RMDs are there for a reason. They weren't there just because. It's something that was put in place many many years ago because Uncle Sam said, "Hey, we want our slice of the pie."

Fortunately, this client I know you're talking about, they're philanthropic. Does that help them in this case?

Yeah. Really any client that's philanthropic, if they have these RMDs, these required minimum distributions, if you have a little bit of a charitable bone in your body, can help in a huge way because we have these things called charitable distributions that can be made from an IRA. So you can take up to, I believe in 2026 the number is what, 111,000. Is that right?

Something on that order.

So check me on that. I will be up toight might be a little more than that now.

I think you might be right, Phil. The number is huge. 111.

Right. So $111,000 they can make a contribution to a qualified charity. And that number doesn't cause them any income tax. It's pretty awesome.

Which is really awesome.

So it is easily missed.

Yeah, for sure.

Number one, we saw that this year we found a tax return. This client, it was this client. This client, we found it on their tax return. The QCD was not labeled, was not input the way it should have been. And so that was a $10,000 mistake. So you ask the question, can it help? Well, if you love to give, you're planning to give, you don't want to make that RMD, a required minimum distribution, and then give, right? Because in that case, you take the money, you then write a check to the charity. So yes, you might get to deduct it, but here's the problem. We talk about this in other episodes. If someone's not itemizing, that charitable contribution is not going to help. They still get to itemize. They, or excuse me, if they don't itemize, they get their standard deduction, right? But they lose the benefit of that charitable contribution. And now it's a taxable thing on their tax return because it is a distribution from that IRA.

Double whammy.

It's a double whammy. Now, here's what's cool about RMDs. Not good. They force money out. Required minimum distribution forces you to take money out of the IRA. QCD, qualified charitable distributions. You get that and you get the standard deduction. So, even if you don't itemize, you still get the standard deduction. But if you're using QCD, you can give up to 111,000. And by the way, that satisfies our required minimum distribution.

Yes, it does.

It works some really, really good magic, if you will. There's a lot of good stuff going on inside of a QCD and a lot of people don't know it exists. And a lot of CPAs are missing it.

That's true. It's true. No doubt. All right, Phil. We're going to do a little exercise today and I'm going to pretend that I've aged myself quite a bit. So, I'm 62 years old and I've just retired. My wife is 60. We have about $1.8 million in the 401k IRA environment, a $300,000 brokerage account, no pension, and I haven't touched social security yet. I have two kids, both in their 30s, both doing well. Tell me what's coming down the pipeline as it relates to my RMDs. Don't they start at my age 73?

You start yours at age 75.

Okay.

Yep. Based on the year you're born. Determines now. And Spell, it used to be that everybody did it at 70 and 1/2 years old, and long before your time in the profession it could be younger than that. But 70 and a half was the number that everybody is familiar with. So Spell, if you're born from 1951 to, you're going to distribute at 73. And so if you're born after 1959, then everybody is 75. The number will probably change again. Who knows? We don't really know what Washington will do, but it could change. But right now, if you're born post 1959, 75 years old.

Okay. So in this case, I'm going to have to start my required minimum distribution at my age 75. So that's 13 years for me. Doesn't that mean that my required minimum distribution will be larger when it begins, hypothetically, because the account can grow more?

It depends if that account grows, and in theory you would think that over the next, what is that, 13 years, if it grows traditionally, if you're in the seven, eight, n% kind of rate of return. You take a million dollar account over 13 years, we could easily see that double. And so if that were the case, you're gonna have a pretty sizable distribution.

To be sure. But Phil, so let's say that I'm confused on this. It's my IRA. Can't I just take what I need?

You can until 75. So between now and age 75, you take anything you want. It's up to you. You pay ordinary income tax on the distribution.

Sure.

The thing that people forget, Spell, is when you're going through life and you're deferring money into your 401k or IRA or whatever you're using, you are getting that money into a savings mechanism pre-tax and it's growing without tax. And Uncle Sam says, "At some point, we need to collect the tax on that money." And so they've allowed you to let it grow all these years and at some point they're going to call you and say, "Hey, it's time." And so in this case, it's age 75. So there's a divisor that you'll use. So let's say that account is, say it's up to $2 million now. You're going to divide, in that first year or at age 75, it's around 24. So you're going to use that as your divisor and then that's going to tell you what your distribution is. So whatever that number is, you have no choice, right? Between now and then, you can take whatever you want. You're just going to pay the tax on it. The problem with all of this is people don't plan well for it. And if that account just keeps getting larger, so too will that RMD.

Okay. All right. So, required minimum distribution. Whether I like it or not, it's coming out. What about, Phil? So, I'm 62 and I just retired. Don't necessarily want to touch my social security yet. I've got a brokerage account. Should I just live from my brokerage account?

So, I think a lot of people view it that way. A lot of people think of it that way and they believe, why don't we just let the IRA grow and I'll live off the brokerage account. I think what a lot of people forget, or they just don't know, is this is where tax planning comes into play and it can be worth a lot. So it might be that depending on your income, your tax rate, it could be smarter to make distributions from that IRA from 62 to 75 and let that brokerage account grow, right? Because you're in what a lot of people in our profession refer to as the valley years, right? So, we have this valley where you're not making much income and so now your tax rate is probably going to be at its lowest point.

Okay. No earned income. You're not working. And you don't have pension.

Right. So, you don't have a lot of these things that generate taxable income. We can use our tax brackets now. We can take that distribution from the IRA, fill those tax brackets, stay in that low set of brackets, maybe the 10 or 12, 15 range. Maybe you're comfortable with 20. Whatever the number is, right? But we can take advantage of these years where we don't have earned income. In a lot of cases, it's actually smarter to start pulling from that taxable account for a lot of reasons that I bet we'll get into and we'll talk about more of why that makes sense. And sometimes it's better to do that versus letting that money accumulate only to create a much larger mandatory distribution that you can't control. And here's one more thing to think about, Spell: we don't know where taxes are going.

True.

Here's what we do know. We do know that our country has $40 trillion of debt. We do know that our leaders in this country love to spend. Whichever side of the aisle you're on, they love to spend. It's why we have a $40 trillion debt. And it's why we spend well over a trillion dollars a year in deficit, right? Why we create a deficit in a huge way, right? Just our interest on our debt is a trillion a year, more than a trillion. It's unbelievable. So all of that makes me believe that there's real potential for taxes to rise. So I don't know that it makes sense to keep building assets in accounts that are going to mandatorily make you pull it out and pay tax. So, got to run the numbers, but a lot of times it's better to take that IRA early, start using those dollars earlier, and let the other dollars have time to grow.

What about Roth conversions?

If you're going to do them, those valley years are the time. Okay? Right? That is the opportunistic time for a Roth conversion. I'm not saying it's going to be the right thing for everyone, but if you're going to make a Roth conversion, the last thing you want to do is, when you're in your peak earning year, start converting. That doesn't make sense. And you don't want to wait until you're closer to RMD age. You really want to do it when your earnings are at their lowest, which means your tax rate is at its lowest. And then you want to strategically make those conversions, or potentially make those conversions, letting the tax brackets be used to your advantage. So filling them to a certain degree, making sure you keep that tax rate as low as possible, getting that money into the Roth environment, because now we don't have to worry about RMDs.

True.

If it's in a Roth, no RMD, no income tax. So once it's in, grows without tax, distribute without tax, pass to your heirs without tax.

Nice.

Right. Lot of advantages with the Roth. So if you're going to think about converting a Roth to a Roth, those early years in retirement when there's no earnings, that's the time to do it, or at least the time to consider it.

Okay. Well, so I'm 62. I could take Social Security this year. I know that is the earliest I can take it, but my plan is to delay until 70. What do you think about that?

Well, it depends. If we're going to start doing Roth conversions, we might not want to do that.

Okay.

You're going to create... So, one, first, let's go to the basics. Number one, if you take it at 62, you're going to give up a lot of social security, right? We're going to give up maybe as much as 30%. Right. So the earlier you take it, you're going to give up what it would be if you waited till full retirement age. Got it? I'm not saying that you wait, right?

But if you don't need it and we have other strategies in play, what you don't want is taking a lot of money out of that IRA maybe to convert and causing your social security to be heavily taxed. Right? Up to 85% of your social security can be taxed as ordinary income. And a lot of people don't realize that until they get into it and then they realize, oh, wait a minute. I'm paying tax on something that shouldn't be taxed.

So I think that is another reason why Roth is a strong argument. The more you have in Roth, the less it's going to affect your social security and the more of your social security you get to keep. So starting it at 62, Spell, not a foregone conclusion, right? You're going to take a huge haircut. If you feel like social security is going to be changed or it's not going to be nearly as good for you down the road, maybe you do take it at 62. But every time you pull one of those levers, we have to think about other things that are going to be affected. Right. So it's not just a gimme. It's not an easy thing to conclude. You got to do some...

Got to do a little planning and testing around that.

I guess this would require additional planning and testing. But what about Medicare? I'm not really thinking about Medicare now because that starts at 65. Right. So, I'm not even going to worry about that or where my money is coming from leading up till Medicare begins at my age 65. Would you agree with that? Am I missing something there?

Well, not necessarily. Because the more income you have at age 65, you have a set of tax brackets that are not part of the ordinary income tax brackets. You have a set of tax brackets referred to as IRMAA. And so depending on how much money you're making, distributions from an IRA, by the way, count. So if you're pulling money from that IRA, it's growing. It could cause you to pay a lot more tax on your Medicare, on that supplemental or on your Part B and your Part D premiums, right? So, you can end up paying more. Okay?

And those tax brackets, Spell, are not like ordinary income tax brackets. If you go $1 over, it's retroactive. Versus traditional tax brackets. When you think about ordinary income, it's a graduated system, right? So you can fill up one tax bracket and maybe you have 20,000 in the next bracket. Well, only the 20,000 gets taxed at the next bracket, right? It doesn't retro. In the IRMAA world, it's retroactive. So, you go over $1, everything rolls up to that next bracket. You're going to pay a lot of extra dollars for that coverage. Under Medicare. So, you have to think about that.

Yeah, for sure. So, the Medicare surcharges are factored for how many years before I turn 65?

So you don't have to worry about those until you're 65, until you're taking Medicare. And then it will hit you two years later. So let's say that your income goes over and throws you into one of those IRMAA brackets above the standard. You won't know it for two years.

Gotcha.

Right. And so, but then you can't undo it. So then you're going to have to deal with that higher cost. CPAs tend to miss that. A lot of planners tend to miss that and all that income flows. All of a sudden you get this hit from that IRMAA perspective and so now you're paying more and you can't change it and you got to live with that until you either reduce your income, and if you can't reduce your income then you just have to live with a much higher rate that is directly connected to that Medicare.

Yeah. Can be pretty penalizing. Okay. And then I guess finally, Phil, what I'm thinking about is my kids. They're in their 30s and they're both doing really well. I've got this 1.8 million tax deferred investment vehicle. By the time I start taking required minimum distributions, I expect that account to at least double cuz we're talking about another 10 years, actually another 13 years before I start taking RMDs. How will that affect my kids? How big of a tax bite will that be for my kids if something were to happen to me?

It could be pretty large. Could be pretty large. So I think now you have to ask yourself the question, what's more important? Is it what I leave behind or am I more focused on now? Am I more focused on me and my income needs or am I more focused on my estate planning? Maybe you should be focused on both of those. But if that IRA reaches, let's say three and a half, $4 million. So one, you're going to have a pretty healthy distribution that's mandatory at age 75, might be a couple hundred,000.

Yeah.

And so you're going to be paying tax on that. That is going to cause you to pay more on your Medicare benefits. So that's going to be affected. And then when you pass and leave all of that to your children, they are going to have 10 years to get all of that money out of the IRA. They can inherit it. And they're going to have 10 years to unwind that IRA. And so if it's $4 million, they might have to take required minimum distributions depending, right? But worst, best case, they've got 10 years and it's got to be out of that environment. So you can imagine, especially if they're in their highest earning years, they could be paying a really large amount on the distributions from your IRA.

So I think at 62 you've got this great window to start planning and that planning is not just about your RMDs but that is one part of it. So the more we can get into Roth, for example, the fewer dollars you have to worry about distributing under the RMD rules and the more we can deliver to your heirs. So when you pass, your children can inherit that Roth. If we have a lot in that Roth IRA, they can inherit that with zero tax and there's no concern about how fast they have to get it out because there's no tax.

Now, they still have to get it out in 10 years, but it's not ordinary income taxable, but there's no ordinary income tax.

That's right.

Okay, that makes sense. All right, Phil, what I think you're telling me is somewhat in flies in the face of what I've heard my entire career in that people have always said, "Max out your 401k, max out your 401k, max out your 401k." And I've done that. But now it seems like you're saying that that may not have been the best idea. Is that what you're saying?

I'm saying that I think you're right. I think a lot of people have always felt like you take the money that has the least amount of tax so you can let the other money grow. Sometimes I think that logic works. The problem though is that everybody's different. Everyone's tax situation is different. In today's, Spell, we have larger IRAs than we've ever seen.

Yeah. They're big.

And so qualified dollars cost a lot of money to the IRA holder and to the heirs. I think today by and large trying to plan better for tax events just makes more sense and it's not as simple as saying take the money with the least amount of tax by now and let the other money continue to grow tax deferred. That was always the argument that so many people made. I don't always disagree with that because depending on the size of that bucket of money, your tax rate might not really be that big of a deal, right? So, distributions may not be that painful.

But for people with these large IRAs that represent the largest amount of their wealth, you have to consider which one makes more sense. And a lot of times getting that money that we know Uncle Sam has rights to roughly a third of it.

Yeah, that's a big number.

It's a big number. And the larger that account gets, the more you're going to lose to Uncle Sam. And depending on where your kids are in their earning years, all of those things can make the gravity of this thing that much greater. And I think people don't recognize that. So I'm not saying that everything you've heard just falls apart and has no validity. I am saying that everybody's plan needs to be carefully considered because some people it makes more sense to convert to Roth. Other people I think it makes sense to leave things alone.

Yeah. Okay. Okay, Phil, that makes sense to me. That's good advice. I think generally speaking, someone who is in this situation sounds like they need to talk to someone with the ability to plan and to look under the different stones so that nothing gets missed for this person. And I'm taking myself out of the 62year-old body now, so I'm happy to be back to myself. But for the person who's got a 10-year window, just go through, from a high level, what can be done in terms of planning? What tools do we have available that can help reduce some of the mandatory tax bite that's brought about by the required minimum distributions?

And it all goes back to your circumstances, where you are in life. And so I think if you've got a bucket of money that's non-qualified, so money that's already been taxed, and you've got a bucket of qualified money that could potentially, if managed properly and grows, it's going to cause those RMDs. So all of that has to be considered. So I think, Spell, first if you're worried about income tax today and you're already in a higher tax bracket, you probably don't want to use qualified dollars, you don't want to pull more out, right? So, depending on the situation, there are those times when you would use qualified money first. But in that case, if you're in a high tax bracket already, you might need to use some of that non-qualified money first. Okay.

Secondly would be if you need cash for living expenses today, and maybe you're in a lower tax bracket, maybe it's not as bad, you might want to use some of the qualified money and go ahead and begin to spend some of that. And then of course, so everybody's situation's different. What I'd really like to see is more of a combination. And I think it'd be great if people plan to do some of the conversion, get some money into Roth, depending on where you are at 62 years old, if they have 10 or 12 years to plan for this thing and they don't have earned income and their living expenses are reasonable. There could be an opportunity to do some of both.

So, you might spend some of that non-qualified money, the already taxed money, to pay some of the taxes that will be due on the money that you pull out of the IRA to make the conversion to a Roth. And in doing that, you accomplish several things. One, you reduce the RMD. Two, you reduce the inheritance tax that we know is embedded. Uncle Sam's going to get theirs regardless, whether you spend it during your life or whether someone gets it at the end of your life, right? Uncle Sam's gonna get there.

So you reduce the RMD, you get to control that a bit more. You reduce what your children or whoever inherits your money, you reduce what they're going to pay. So, that creates greater efficiency, allows your wealth to work more for you and for someone else for longer. So, I don't think there's just not a one-sizefits-all. All of this has to be considered. The sweet spot depends on a person's situation. So, got to have someone who can plan that. Look at the today. What do they really need? What are they trying to accomplish? There is a path to success for every one of these possibilities or every one of these situations, but it requires planning. I don't think it's one sizefits-all. Anytime someone hears that, they should probably run. They need a different advice.

Yeah. Head for the hills.

That's right. Head for the hills. I don't necessarily...

And most people probably don't love the idea of being in partnership with someone that they don't get a choice whether they're in partnership or not. So, it's annoying.

If we had Roth years and years and years ago, 50 years ago, if we knew about a Roth, maybe people would have done more of that, but this kind of planning was not being done back then. Taxes were not talked about nearly as much, but they are today. And so planning is good, right? We should plan, try to avoid these things if we can.

Yeah. So, Phil, to land this plane, if someone were to go meet with their CPA this week and they were only able to offer or ask one question of their CPA, and mind you, it's October 15th, so we're up against the deadline, but what would you tell a listener to go ask their CPA today? They get one question.

If they were talking to their CPA today, they probably would have a hard time reaching them because it's October 15th. Good luck. But if they were sitting with their CPA, I think I would ask, "What have we done this year to plan for my lowest tax bill come October 15th? Have we taken advantage of everything that we can?

And what should I be thinking about from now until the end of this year?" 12:31 is the deadline, not April 15th. People should think of 12:31. What should I do between now and then, and see what the CPA can offer, and chances are they're going to have a war chest of things they can share with you, but they may not if you don't ask.

Yeah, it's good. Okay, perfect. Last thing, Phil. Which of the 10 Elements ran into each other in this story?

Tax strategies.

Yes. Certainly a big part of this.

Yes. And retirement income.

Dang, I didn't get you again. Nice job. That's right. Very nice.