The Case for Taxable Retirement Investing: Part 2

Tax-deferred retirement plans offer clear tax-reduction benefits for retirement savers while they are working. But these accounts carry tax consequences that aren’t always anticipated in retirement. Part and parcel of turning 72 is the need to take annual required minimum distributions (RMDs) associated with traditional IRA, 401(k) and 403(b) plans. Regardless of the type of investments you hold, RMDs are generally taxed at your marginal tax rate,¹ which is typically much higher than current capital gains and dividend tax rates.

Accounting for Taxes
Many retirees are surprised to find that they must make federal and state quarterly estimated payments based on the amount of their RMD, which can effectively reduce the amount they take out of their accounts by 25% or 30% or more.

Investing in a taxable account before retirement is one strategy that can potentially mitigate the adverse effect that tax-deferred savings can have once you are retired. We discussed some of the advantages of this strategy for pre-retirees in The Case for Taxable Retirement Investing: Part 1.

Quantifying the Impact
Consider the following hypothetical example. For a retiree with a $1 million retirement account who turned 72 in 2021, the FINRA Required Minimum Distribution Calculator estimates a withdrawal factor² of 25.6, resulting in additional annual income of $39,063.³ Depending on your federal bracket, this could generate a tax liability of more than $1000 a month, reducing that withdrawal by $12,500.

Effect of Taxes on RMDs: Federal 2021 Federal Tax Brackets

RMD Amount	Federal Bracket4	Estimated Tax	RMD After Tax
$39,062.50	22%	$8,593.75	$30,468.75
$39,062.50	24%	$9,375.00	$29,687.50
$39,062.50	32%	$12,500.00	$26,562.50
$39,062.50	35%	$13,671.88	$25,390.62
$39,062.50	37%	$14,453.13	$24,609.37

This sample case doesn’t include the impact of state and local taxes, where applicable. And in some cases, taking an RMD can bump you up to a higher tax bracket, meaning that all of your income over a certain threshold will be taxed at a higher rate than if you had not received the RMD. Investors are not provided an option regarding the RMD – they must take it, whether they need to or not. That’s why it’s important to consult your financial professional and tax advisor to discuss how RMDs are likely to affect your personal tax situation.

Taxable Accounts Don’t Have Distribution Requirements
But remember, RMDs apply only to retirement plan accounts. Taxable accounts have no distribution requirements, so investments are free to keep compounding over time. While taxable accounts are often an afterthought in retirement planning, using them correctly may help avoid this type of RMD problem.