In response to my recent article about RMD timing, a handful of people wrote in with comments/questions similar to this one:
“Maybe I am missing something, but to the extent that there is significant equity in the retirement account, then isn’t it better to take the RMD earlier in the year so that growth is ultimately taxed at capital gains rates rather than as ordinary income from future RMDs? Thanks for any clarification.”
A key point to understand about traditional IRAs is that the growth is tax-free. This is fundamental to understanding all of the “Roth or tax-deferred” decisions as well as Roth conversion decisions.
A traditional IRA can be thought of as a Roth IRA (i.e., an account with tax-free growth) in which the government owns a share. (The other two differences are that Roth IRAs don’t have RMDs during the original owner’s lifetime, and with Roth IRAs you can withdraw contributions at any time tax-free and penalty-free. Those differences are often important. But in terms of the math of how the accounts grow, there is no difference.)
The Classic Example (Contributions)
The classic example illustrating this point is in the context of whether to contribute to a Roth or tax-deferred account. And the point of the illustration is that the two options work out the same, if the tax rate at the time of contribution is the same as the tax rate at the time of distribution.
Let’s imagine:
- Reiley has a current marginal tax rate of 20%, and we can somehow predict that her future marginal tax rate will be 20% as well. (Of course this level of certainty is entirely unrealistic, but the point here is just to demonstrate the math.)
- Reiley can currently afford to make a $2,000 contribution to a Roth IRA, or she could make a $2,500 contribution to a traditional IRA (because the deductible contribution would net her $500 in tax savings this year, so her net out-of-pocket would be $2,000).
- In either case, the contribution will eventually grow to eight-times its initial value, and then be distributed.
If Reiley contributes $2,000 to a Roth IRA, it will turn into $16,000. And that $16,000 distribution will be tax-free.
If Reiley contributes $2,500 to a traditional IRA, it will turn into $20,000. That $20,000 distribution will be taxable at at 20% rate ($4,000 of tax), leaving Reiley with $16,000.
Point being, if the tax rate is the same at the time of contribution and the time of distribution, the after-tax amount available for spending will be the same. In other words:
- We have no preference between paying tax at the start (in the case of Roth) or at the end (in the case of tax-deferred) if the tax rate is the same.
- And #1 is true because both the Roth IRA and the traditional IRA grow tax-free.
RMDs (And When to Take Them)
Now let’s move on to the topic at hand (RMDs), so we can see how the same concept (tax-free growth in a traditional IRA) is applicable.
Let’s imagine:
- Your RMD for this year is $30,000.
- The dollars in question will earn a 10% return this year.
- The tax rate you pay on the distribution will be 22%.
If you take the RMD on January 1, it will be $30,000 before the distribution. And after accounting for the 22% tax, it will be $23,400 that actually gets invested in the taxable account. That $23,400 grows by 10% over the course of the year, to $25,740.
Conversely, if you take the RMD on December 31 (not a good idea in real life to take it on literally the last day of the year, but let’s ignore that for a moment), the $30,000 from the start of the year will have grown to $33,000 by that point. If you take out the whole $33,000, pay tax at 22%, what’s left is $25,740.
Not coincidentally, those two amounts are exactly the same. $25,740 in either case. It’s the same exact amount that’s left after taxes, whether you take the distribution at the start or end of the year, because we don’t care whether we pay the tax at the start or end of the year, due to the commutative property of multiplication.
But we’ve left out something important!
In the “RMD at the start of the year” case, when the $23,400 that’s now in your taxable brokerage account grows to $25,740, some portion of that is usually going to be taxable, either as interest, dividends, or capital gains. (Even if the dollars are kept entirely in stocks, and you’re in the income range where qualified dividends and long-term capital gains are taxed at a 0% rate, most stock funds still pay some amount of unqualified dividends.) And thus the “RMD at the start of the year” strategy falls behind by however much tax gets paid on the return earned in the taxable account over the course of the year. (Again, returns in an IRA are tax-free, whereas returns earned in a taxable account generally are not.)
In addition, to illustrate the “it’s the same dollar amount” concept in the example above, I was assuming that, if the RMD for the year was $30,000 and the dollars in question grow to $33,000 over the course of the year, you take out the whole $33,000 if you’re following an “RMD at year-end” strategy. But you don’t actually have to do that. The RMD is still just $30,000.
Overall point being, as a general principle, because growth in IRAs isn’t taxed whereas growth in taxable accounts usually is taxed to some extent, we want to keep our money in IRAs for as long as possible.
What is the Best Age to Claim Social Security?
Read the answers to this question and several other Social Security questions in my latest book:
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