There are three main categories of investments:
- Taxable (brokerage) accounts that generate taxable income on annual distributions and capital gains only when they are sold (“Tax Now”)
- Tax-free accounts—such as Roth IRAs, Roth 401(k)s, municipal bonds, and municipal bond funds—that are not taxed (“Tax Never”)
- Tax-deferred accounts—such as traditional IRAs and qualified employer plans, including 401(k)s and 403(b)s—where withdrawals and taxes are typically postponed until retirement (“Tax Later”)
This article will discuss tax-deferred accounts, particularly how they affect older adults when income taxes are due on account withdrawals. For some older adults, later life income can be greater than when they were in their working years, even though they were told in their 20s and 30s that they would earn less.
Retirement Plan History
The first 401(k) plan was implemented in 1978 about three weeks after section 401(k) of the tax code was enacted. The first traditional IRA for all workers began in 1982. Therefore, baby boomers (age 61 to 79 in 2025) were “guinea pigs” for career-long tax-deferred retirement savings plans.
The Deal That Workers Made
When retirees were working, the government offered them two choices:
- Option A: Pay taxes now on a known current income at a known tax rate. There is no retirement savings tax write-off, but you can invest after-tax dollars.
- Option B: Pay taxes later on an unknown future income at an unknown future tax rate by investing pre-tax dollars in a tax-deferred account.
When workers elect option B, they gamble that they will have less income and be in a lower tax bracket vs. their working years. They also benefit from decades of tax-deferred compound interest.
Required Minimum Distributions (RMDs)
Required minimum distributions (RMDs) are mandatory withdrawals that retirees with tax-deferred accounts must make in later life. The starting age for RMDs depends on an account owner’s year of birth: age 73 if born between 1951 and 1959 and age 75 if born in 1960 or later.
Retirees can have different reactions to RMDs:
- Angry (“the government is taking my money”) and confused (“How do I get started?”)
- Grateful (for their accumulated wealth) and strategic (taking actions to minimize taxes)
Anger won’t get you anywhere. RMD rules are the law. This article will explain the RMD process. Grateful and strategic responses are positive ways to view RMDs as a fact of (tax) life for older adults.
RMD Calculations
Two key pieces of data are needed: the closing balance in a tax-deferred account on December 31 of the previous year and the life expectancy factor (divisor) for an account owner’s age in the IRS Uniform Lifetime Table. The prior year account balance is divided by an age-based divisor. For example, the age-based divisor for age 73 is 26.5. Below is an illustration of RMDs for two different account balances:
- $50,000 Balance: $50,000 ÷ 26.5 = RMD of $1,887 (rounded)
- $500,000 Balance: $500,000 ÷ 26.5 = RMD of $18,868 (rounded)
First-time RMDs can be legally postponed to April 1 of the year following RMD start age. However, if that is done, two RMD withdrawals must be taken the following year (for the current year and prior year).
RMD Waterfall
As retirees get older, age-based divisors for RMDs get smaller. As a result, the RMD withdrawal percentage (of account assets) keeps increasing. At age 73, tax-deferred account owners withdraw 3.77% of their account balance. At ages 80, 85, 90, and 100, the percentages are 4.96%, 6.25%, 8.20%, and 15.63%, respectively.
The IRS table goes up to age 120+, at which time 50% of the remaining account balance must be withdrawn. This increasing depletion of tax-deferred account balances is often called the “RMD Waterfall” because that is what it looks like when plotted on a graph.
RMD Tax Impacts
RMDs get added to account owners’ other sources of taxable income, which can trigger:
- Tax on Social Security benefits starting at a $25,000 combined income for single taxpayers and $32,000 for married couples filing jointly.
- Income-related monthly adjusted amount (IRMAA) Medicare Part B and Part D premium surcharges for higher-income retirees.
- The 3.8% net investment income tax (NIIT) on investment earnings for higher earners.
Income tax withholding for RMDs can be done through tax-deferred account custodians or quarterly estimated tax payments or both. Some account owners elect to begin RMD withdrawals as early as age 59½ (the age when the 10% penalty for early withdrawals goes away) to stretch their tax liability over a longer period of time or because they need the money.
Tax Mitigation Strategies
No one wants to bump up their tax bracket if they can help it. Three common ways to mitigate the tax impact of RMDs are:
- A qualified charitable distribution (QCD) from a traditional IRA to a qualified charity starting at age 70½. Tax-deferred account funds that are donated to charities are not subject to RMDs.
- Roth conversions (i.e., converting a tax-deferred traditional account to a tax-free Roth account). Roth conversions are best done in stages and/or made in low-income years because taxes are due on the converted amount in the year that a Roth conversion is made.
- A combination of QCDs and Roth conversions.
RMD Uses
Money withdrawn from tax-deferred accounts can be spent (on basic needs or “extras”), gifted (to family, friends, and/or charity), or resaved in taxable accounts or Roth IRAs (if qualified with earned income). This RMD Planning Worksheet can help you calculate how much to set aside for income taxes and for spending, gifting, and re-saving, as described above.
Tax-Deferred Account Beneficiaries
It is unlikely that tax-deferred retirement plan “super savers” (i.e., those who begin saving early in life and “max out” their annual contributions up to the IRS limit) will die without leaving some money in tax-deferred plans. Beneficiaries are the people or entities (e.g., charities) who inherit tax-deferred accounts when the account owner dies.
It is very important to keep beneficiary designations up to date and to name contingent beneficiaries in case the primary beneficiary predeceases you or disclaims the assets. This Beneficiary and Personal Representative Designations Worksheet can help you list all your designated beneficiaries and personal representatives for your estate in one document.
Tax-Deferred Account Consolidation
Many financial experts recommend account consolidation to make it easier to calculate and withdraw RMDs. For example, four IRAs get consolidated into one. Other consolidation benefits include fewer account management fees and less maintenance (e.g., account logins, tax statements, and emails).
The best practice process for tax-deferred account consolidation is to identify the “sending” account and “receiving” account and contact plan custodians on both ends. Then a direct (trustee to trustee) rollover is made from one account custodian to another.
Final Thoughts
For decades, workers funding tax-deferred accounts were in the accumulation phase of retirement planning. Taking withdrawals from retirement savings begins the decumulation phase. Three keys to success are 1. understanding how RMDs are calculated, 2. making withdrawals by December 31 of each calendar year (following the first year of RMD age, where there is a choice), and 3. developing a plan for income tax withholding and spending, saving, or resaving the balance.
