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  • Writer's picturePace Accounting

Beware the Tax Torpedo

Large retirement account balances can cause Social Security tax problems.

Putting off distributions and holding assets in your retirement accounts as long as possible may seem like a good idea, but waiting too long can cause a major tax problem. When you reach 70 ½, the trigger requiring minimum distributions (RMDs) from qualified retirement accounts is pulled and a potential tax torpedo is launched.

RMDs explained

RMDs apply to Traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k), 403(b) and other defined contribution plans. Amounts not distributed on a timely basis can be subject to a 50% penalty. Thankfully, the RMD rules do not apply to Roth IRAs. Required withdrawals must be completed by April 1 following the year you turn 70 ½ and Dec. 31 every year thereafter.

The RMD rules ensure the deferred tax benefit for certain retirement accounts does not go indefinitely into the future. In other words, the IRS now wants their cut by applying income taxes to your tax-deferred savings account balances. The amount you must take out each year is based upon your age, your spouse’s age, and your filing status.

The tax torpedo

If you continue to wait to start taking money out of your retirement accounts, the balance in your accounts may be very high when you reach age 70 ½. These higher balances mean a higher annual taxable withdrawal amount. If your required retirement plan distribution is large enough, it may apply a higher marginal tax rate on your withdrawals, as well as trigger taxes on your Social Security. Depending on your income and filing status, up to 85 percent of your Social Security benefit could now be subject to income tax.

Some tips

Plan withdrawals.

Once you hit age 59 ½ you may withdraw money from qualified tax-deferred retirement accounts without experiencing an early withdrawal penalty. To reduce future tax risk on your Social Security, manage annual disbursements from your retirement account(s) to be more tax efficient when you reach age 70½.

Starting Social Security.

You may begin full Social Security Benefits after you reach your minimum retirement age. However, your benefit amount can increase if you delay your start date up until age 70. Consider this as part of your plan to manage a potential tax torpedo.

See an advisor.

There are many moving parts in planning for retirement. These include Social Security Benefits, pension plans, savings, and retirement accounts. Ask for help to create the proper plan for you and your family. One element of the plan should include being tax efficient.

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