Author Topic: What is the point of RMDs?  (Read 633 times)

zolotiyeruki

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What is the point of RMDs?
« on: February 10, 2021, 09:28:59 AM »
So, I'm a long, long way from needing to worry about RMDs, but want to understand them better.  And I have to say that I simply don't get what the goal of RMDs is.  Wikipedia says that it's to limit situations where a retiree passes a large tax-deferred sum to a beneficiary.  But as I understand it, the beneficiaries can either take distributions over several years (and pay taxes on them), or in the case of a surviving spouse, they can roll it into their own IRA, and defer taxes until 59.5, or whatever.

Or, put another way (and yes, I'm simplifying here), in the current situation, the retiree could take the RMD, pay the taxes, and invest the rest in a taxable account.  Without the RMD, the retiree's IRA would pass on to their kids, who would then take distributions and pay the taxes.

In either case, the money (and the gains) get taxed.  So what's the point of forcing the money to be withdrawn and taxed during the retiree's lifespan?  What am I missing here?


IsThisAGoodUsername

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Re: What is the point of RMDs?
« Reply #1 on: February 10, 2021, 09:39:18 AM »
Pure and simple, which you've already identified: the US Government wants their tax revenue sooner rather than later (or perhaps never).  Remember, there's step up basis upon death, so the tax revenue from that change in basis is lost.

Foolish hypothetical situation: you make $10,000 worth of pre-tax contributions annually to your workplace 401k for 20 years. This $200,000 grows to $1m. You die. Your son inherits and the step up basis is now $1m. He immediately takes a $600,000 distribution and pays no taxes. The remaining $400,000 grows over time to $1.5m. Your son dies. Your son's daughter, your granddaughter, inherits the $1.5m and the new step up basis is $1.5m. She immediately takes a $500,000 distribution and pays no taxes. Repeat every generation. No tax was ever paid on the initial $200,000 and no tax is ever paid on the distributions. Your family is rich.  Government is sad.

EDIT: Correction. Step up doesn't apply to 401k/IRA accounts. Thanks, @Firepants for the correction.
« Last Edit: February 10, 2021, 06:21:58 PM by IsThisAGoodUsername »

CoffeeR

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Re: What is the point of RMDs?
« Reply #2 on: February 10, 2021, 10:03:42 AM »
As stated, the government wants their taxes sooner, rather then later. Also remember, it used to be possible to do a stretch-IRA enabling heirs to defer taxes for a long time. This is no longer possible due to changes in the law (inherited IRA's have to be liquidated within 10 years), so the need for RMD's to get revenue has decreased, but laws like this do not change quickly even if the reason for their existence is no longer as strong as it once was.
« Last Edit: February 10, 2021, 09:42:55 PM by CoffeeR »

Firepants

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Re: What is the point of RMDs?
« Reply #3 on: February 10, 2021, 10:14:59 AM »
IRAs don't qualify for step up basis upon death. The beneficiary of an IRA will pay ordinary income tax on any distributions at their rate.

zolotiyeruki

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Re: What is the point of RMDs?
« Reply #4 on: February 10, 2021, 10:39:57 AM »
Thanks for the replies.  I think CoffeeR is probably closest to being right.  I wasn't aware of the term "stretch IRA," and now that I'm more informed, I can understand RMDs a *little* better in that context.  Since stretch IRAs aren't a thing any more, that money is gonna be taxed in the reasonably-near future either way, so RMDs make less sense, but they're still in place.  @IsThisAGoodUsername as Firepants said, the step-up basis only applies to taxable accounts.

Actually, the more I think about it, the more it seems the government would prefer that the inheritors cash out the IRA--they're more likely to be in their earning/accumulation phase, and the IRA distributions would likely be taxed at a higher marginal rate than the retiree's.

ixtap

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Re: What is the point of RMDs?
« Reply #5 on: February 10, 2021, 10:43:45 AM »
Thanks for the replies.  I think CoffeeR is probably closest to being right.  I wasn't aware of the term "stretch IRA," and now that I'm more informed, I can understand RMDs a *little* better in that context.  Since stretch IRAs aren't a thing any more, that money is gonna be taxed in the reasonably-near future either way, so RMDs make less sense, but they're still in place.  @IsThisAGoodUsername as Firepants said, the step-up basis only applies to taxable accounts.

Actually, the more I think about it, the more it seems the government would prefer that the inheritors cash out the IRA--they're more likely to be in their earning/accumulation phase, and the IRA distributions would likely be taxed at a higher marginal rate than the retiree's.

Budgeting tends to look at 10 year effects. As life expectancies of the aged increase (much of recent decreases in overall life expectancy are attributed to deaths in 20s, 30s and 40s rather than old people dying younger), eliminating RMDs is less likely.

slappy

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Re: What is the point of RMDs?
« Reply #6 on: February 10, 2021, 01:04:26 PM »
Thanks for the replies.  I think CoffeeR is probably closest to being right.  I wasn't aware of the term "stretch IRA," and now that I'm more informed, I can understand RMDs a *little* better in that context.  Since stretch IRAs aren't a thing any more, that money is gonna be taxed in the reasonably-near future either way, so RMDs make less sense, but they're still in place.  @IsThisAGoodUsername as Firepants said, the step-up basis only applies to taxable accounts.

Actually, the more I think about it, the more it seems the government would prefer that the inheritors cash out the IRA--they're more likely to be in their earning/accumulation phase, and the IRA distributions would likely be taxed at a higher marginal rate than the retiree's.

But then they have to wait for the original person to die. If a person doesn't die until 90, that's 18 years of taxes the government is missing out on.

zolotiyeruki

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Re: What is the point of RMDs?
« Reply #7 on: February 10, 2021, 02:53:48 PM »
Thanks for the replies.  I think CoffeeR is probably closest to being right.  I wasn't aware of the term "stretch IRA," and now that I'm more informed, I can understand RMDs a *little* better in that context.  Since stretch IRAs aren't a thing any more, that money is gonna be taxed in the reasonably-near future either way, so RMDs make less sense, but they're still in place.  @IsThisAGoodUsername as Firepants said, the step-up basis only applies to taxable accounts.

Actually, the more I think about it, the more it seems the government would prefer that the inheritors cash out the IRA--they're more likely to be in their earning/accumulation phase, and the IRA distributions would likely be taxed at a higher marginal rate than the retiree's.

But then they have to wait for the original person to die. If a person doesn't die until 90, that's 18 years of taxes the government is missing out on.
But presumably, the money is growing all that time, so when the person dies, the government gets to tax a greater amount!

IsThisAGoodUsername

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Re: What is the point of RMDs?
« Reply #8 on: February 10, 2021, 06:20:03 PM »
@IsThisAGoodUsername as Firepants said, the step-up basis only applies to taxable accounts.

Ah yes, thx. Sorry, I was lumping together wrong accounts.

Frankies Girl

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Re: What is the point of RMDs?
« Reply #9 on: February 10, 2021, 10:03:49 PM »
Quote
But then they have to wait for the original person to die. If a person doesn't die until 90, that's 18 years of taxes the government is missing out on.

For the original owners, they MUST take a RMD from any tax-deferred accounts like traditional/rollover IRA or 401k (and 403b I think but don't quote me) starting at age 72. You can volunteer to take a distribution (penalty free) any time after 59.5, but your REQUIRED minimum distribution has to be taken at 72 or there are some serious penalties and interest they can levy. So no, 18 years of taxes are being assessed/collected if the person hits 72 and is in a high enough bracket to pay a % on their taxable income (RMDs count as income, just not earned income).



I have an old school cool stretch inherited IRA (iIRA) and it IS special and awesome. I have not paid one penny in taxes in nearly a decade because I can work the system to keep my taxable income under the thresholds, so the government is likely trying to prevent that lost tax from becoming a widespread thing.

My dad was already at the age to be taking RMDs, so they were pretty large for him but once I got it, the RMDs (based on MY life expectancy and the amount in the iIRA as of EOY) amounted to a nice amount but won't push me into a higher tax bracket as I quit my job once I figured out this FIRE thing. I was/am still lucky enough to not have to pay any taxes but still can take extra if I needed. iIRA distributions are considered ordinary income and not subject to penalties for withdrawing for either the RMD or any additional money. The darn thing just keeps GROWING. I have had it for ~8 years and it's way larger that what I started with despite just doing index funds.

It really is pretty horrible what they did to iIRAs. 10 years to deplete it is NOT a good idea since most folks will likely inherit during their highest earning years if the owners die in their 70s-80s; I think making it into the 90s is still an outlier more than the norm. so I believe (no idea, not an expert) it was designed to get even more taxes since now the RMDs are based off of either the original owner's age or the heir's now finite 10 year deadline, so either way they win.

And lots of people DO cash them out. Mostly because they don't know any better. I read up on them so I knew it was a bad idea and even tried to warn my sibling not to do this... and they ignored me and cashed out one "small" iIRA (thank dog they didn't get around to the large one!). So that plus their earned income almost tripled their MAGI, and then was SHOCKED when they owed thousands and thousands their next tax return. So it is likely the government is hoping this becomes way more popular even though it is a terrible idea for most everyone. If they have to do it no matter what in 10 years, why not just get it done ASAP? Don't think about the ramifications - just get the money!

Apologies if I got anything wrong and someone needs to correct me (let me know and I'll fix it). But this was my experience so far.

« Last Edit: February 10, 2021, 10:07:39 PM by Frankies Girl »