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You Can’t Make Me! RMDs and Your IRA for the CFP Exam

Hand holding a tree

Americans tend to be a pretty independent bunch. You can’t tell us what to do! Like with trans-fats in food: we didn’t even know what they were until the government wanted to take them away. Then we said, “Congress! Don’t mess with my Twinkie.”

We also don’t like being dictated to with regard to our retirement dollars. Currently, the majority of Americans save for retirement in Traditional IRAs, 401(k)’s, and Roth IRAs. While these plans have many similarities, several key differences affect financial planners’ recommendations for individual clients.

You Can't Make Me! Well, They Can

A Traditional IRA – where you contribute tax-deferred dollars – specifies that you must take distributions of those funds at a certain age. For 2023, the IRS states that the age at which account owners must start taking required minimum distributions goes up from age 72 to age 73, so individuals born in 1951 must receive their first required minimum distribution by April 1, 2025. These “Required Minimum Distributions,” based on a formula of start-of-year account balance divided by a published life expectancy, wield a heavy penalty if not obeyed. Participants must pay taxes at their current tax bracket on the funds when distributed. Even if the IRA owner is in a lower tax bracket than during his or her working years, the tax burden can hurt because of the fixed income status of these retired clients.

A Roth IRA – where you contribute post-tax dollars – doesn’t require that you take any distributions ever during your lifetime. And when you do distribute, you pay no tax. You’ve already paid the piper, and now you get to dance for free. For a client on a fixed income, this kind of tax relief can make a big difference.

Another financial benefit of Roth IRA distributions is their exclusion from taxable income. Therefore, they don’t increase a taxpayer’s adjusted gross income (AGI). As a result, taxpayers taking Roth distributions instead of taxable distributions can reduce or eliminate the 3.8% Net Income Investment Tax (NIIT). In contrast, distributions from Traditional IRAs and most employer-sponsored retirement plans increase a client’s AGI and subject him or her to additional NIIT because the NIIT is assessed against the lesser of AGI in excess of an indexed amount or net investment income.

Depending on their current tax situation and the tax bracket of their retirement, be sure to consider recommending the Roth IRA to your clients. That helps mitigate the you can't make me vibe.

By Kathryn Hauer - writing for the Starks Boot Camp™ Review for the CFP® Exam|CFP® Exam Information – The RMD.

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