Reduce RMDs by Millions And Save BIG in Taxes After FIRE

Last Updated: November 10, 2022

In previous posts, I outlined an early retirement withdrawal method called the Tax and Penalty Minimization method, and I discussed Required Minimum Distributions (RMDs) that can begin at age 72 (and soon 75 it looks like) and can result in significant taxable income and thus taxes.

In this post, we’re going to show just how much better the TPM method is than the traditional withdrawal method for reducing RMDs and thus your tax bill. Especially if you’re an early retiree and can take advantage of decades of good tax planning.

Lower RMDs

As mentioned in the above withdrawal strategy post, “the TPM method shifts much more of the growth from the PreTax and 457(b) accounts to the Roth and taxable accounts”, and thus “the TPM method will result in much lower RMDs (and thus much lower taxes) than the Traditional method.”

In other words, during your working years you want to max out your pre-tax retirement account contributions to minimize taxes, but after you stop working you want to withdraw the full standard deduction amount every year from your pre-tax accounts to minimize the growth of those accounts and thus minimize your RMDs.

Some people might argue it’s better to keep money in the pre-tax accounts for as long as possible to enable tax free growth as long as possible, but this thinking is mistaken for a couple reasons:

  1. If you roll over the pre-tax funds into a Roth account, then the money can continue to grow tax free, and you won’t pay any taxes on that rollover as long as it matches the standard deduction each year
  2. If you place the funds into a post-tax account, then as long as the dividends received from your post-tax accounts do not exceed the standard deduction (for non-qualified dividends, which in my experience are a small fraction of the dividends we receive) and the much larger 0% long term (LT) capital gains bracket (for qualified dividends, which are the majority of our dividends), and any sales of post-tax lots generate LT cap gains also within the 0% LT cap gains bracket, then you won’t have any tax drag on that account. 

Updated Asset Bookkeeping

Previously I just lumped all pre-tax account balances into a single balance, which works just fine if you’re not filing your taxes with a spouse. But if you ARE, then it’s important to track the separate balances of each person for all tax-advantaged accounts because of all the rules for those accounts that involve your age. E.g., you can’t withdraw from tax-advantaged accounts before age 59.5 without paying a penalty (unless of course you use a Roth ladder), and RMDs start for each person’s pre-tax accounts when that person turns 72. 

SO, I had to do some bookkeeping upgrades to track these balances separately for married couples. I also made the assumption that you will always pull first from the older person’s pre-tax accounts in the TPM method, until they are depleted, to minimize / put off RMDs as long as possible (i.e., in the years between when the older person turns 72 and the younger person turns 72). Note that if there’s a divorce, all retirement accounts are split equally anyways.

Update to Targeting Taxable Social Security Income Method

In the FIRE Withdrawal Strategy Algorithms page and Social Security Income (SSI) post I laid out a method for targeting a particular amount of non-SSI standard income and LT cap gains to ensure you will not pay federal income taxes on that SSI. 

However, as I began to consider the impact of large RMDs on this approach, I realized it needed an overhaul. Especially as the RMDs could easily exceed the user-specified maximum standard income (i.e. the standard deduction) and even the user-specified maximum total income (i.e. all standard income plus LT cap gains). 

Originally I was going to provide the algorithm here, but it made this section and post too long. So instead I just updated the FIRE Withdrawal Strategy Algorithms page to reflect the latest algorithm (and just added a note to the Social Security Income (SSI) post that the algorithm has been updated). 

Example Scenarios

Alrighty, let’s discuss some concrete examples to see the impact of these RMDs.

Betty’s Filing Status: Single

Betty is a 40 year old early retiree with the following attributes:

  • $400K in standard pre-tax accounts (e.g. 401K, 403b, Traditional IRA, etc.)
  • $100K in a 457b pre-tax account
  • $400K in her post-tax account (i.e., “taxable” or “brokerage” account)
  • $80K in her Roth IRA account
  • $20K in cash (thus a total of $1M in assets)
  • $10K in annual qualified dividends from her post-tax account
  • $100 in annual non-qualified dividends from her post-tax account
  • $17K per year in social security income (SSI) once she turns 67
  • Before she turns 65 and can get medicare, she needs to target an income of $50K for ACA subsidies
  • $40K in expenses each year
  • Her expenses will go down by $800 per month when she turns 66, due to paying off her mortgage

We also assume a 7% after-inflation ROI each year for all invested assets (i.e. all assets except the small cash allotment).
Running a 52 year simulation with the TPM withdrawal method, until Betty is age 92, we can see how her assets evolve over that time in current day dollars (again using the historical average 7% after-inflation ROI):

Notice how at age 72 there is a significant bend in the PreTax and PostTaxTotal plots, indicating that RMDs have begun. We can also see the income and corresponding taxes from these RMDs by plotting the income, taxes, and other yearly values over the simulation timespan:

Note how the RMDs are clearly the reason why the TotalStandardIncome and TotalIncome dramatically increase at age 72, as expected. 

Now what if Betty uses the traditional withdrawal method instead? Looking at the assets over time:

We can see that the final total for the traditional method is over a million dollars lower than the TPM method – not a small chunk of change!

What if we plot the differences of these asset plots, so we can see how the traditional method fares against the TPM method?

You can see how the pre-tax accounts are lower for the TPM method than the Traditional method, and the post-tax and Roth accounts are higher for the TPM method than the Traditional method (as expected, because the TPM method is taking maximum advantage of the standard deduction every year to reduce the pre-tax accounts). As a result, at age 72 when RMDs start, the total for the traditional method starts to get hammered by much higher taxes than the TPM method. Thus Betty will be over a million dollars richer in her 90’s using the TPM method instead of the traditional method.

With the TPM method Betty will have to take $3,925,211.60 in RMDs, and with the traditional method she will have to take $5,990,235.25. So Betty will have to take over $2M more required distributions with the traditional method than the TPM method!

How much more taxes will Betty have to pay with the traditional method as a result? Betty will pay $906,436.17 in taxes with the TPM method and $1,588,470.98 in taxes with the traditional method. So Betty will save $682K in taxes, or 43%, with the TPM method! 

And of course any extra taxes paid earlier in the simulation means less growth for the rest of the simulation.

I also have Betty in the diagram at the top of this post.

Bill’s Filing Status: Married Filing Jointly

Bill and his wife Barbara are 40 and 38 year old early retirees with the following attributes:

  • $400K in standard pre-tax accounts ($200K each)
  • $100K in 457b pre-tax accounts ($50K each)
  • $400K in a post-tax account (i.e., “taxable” or “brokerage” account)
  • $80K in Roth IRA accounts ($40K each)
  • $20K in cash (thus a total of $1M in assets)
  • $10K in annual qualified dividends from their post-tax account
  • $100 in annual non-qualified dividends from their post-tax account
  • $34K / year per year in social security income (SSI) ($17K each) once they turn 67
  • Before Barbara turns 65 and thus they can both get medicare, they need to target an income of $50K for ACA subsidies
  • $40K in expenses each year
  • Their expenses will go down by $800 per month when Bill turns 66, due to paying off their mortgage

We also assume a 7% after-inflation ROI each year for all invested assets (i.e. all assets except the small cash allotment).

Running a 52 year simulation with the TPM withdrawal method, until Bill is age 92 and Barbara is age 90, we can see how their assets evolve over that time in current day dollars (again using the historical average 7% after-inflation ROI):

There is less of a noticeable bend in this married couple scenario than the single person scenario. So let’s take a look at the yearly values plot to see when the RMDs start and how big the impact on taxes is:

The age on the x-axis is that of the older person, Bill. So why does it not show the dramatic increase in income from RMDs until Bill is 74? Is there a bug in my code?

Well I thought there might be a bug initially, but then I remembered (and verified) something important: because the TPM method always withdraws entirely from the older person’s pre-tax accounts first (see “Updated Asset Bookkeeping” section above), by the time Bill hit age 72 he and his wife had fully depleted his retirement accounts! Now of course that means Barbara’s pre-tax accounts will be much larger as a result, but most importantly it allows Bill and Barbara to avoid RMDs for another couple years – which is huge for the growth of their assets. 

Now what if Bill and Barbara used the traditional withdrawal method instead? Looking at the assets over time:

We can see that the final total for the traditional method is $1.668M dollars lower than the TPM method – again, not a small chunk of change!

What if we plot the differences of these asset plots, so we can see how the traditional method fares against the TPM method?

Leading up to age 72, all pre-tax accounts are lower for the TPM method than the traditional method, and the post-tax and Roth accounts are higher for the TPM method than the traditional method. So when RMDs start, the traditional method produces much higher RMDs and thus taxes than the TPM method, and the asset total is over $1.6M higher for the TPM method by the time Bill hits 90. I.e. Bill and Barbara will be over $1.6 million dollars richer in their 90’s using the TPM method instead of the traditional method.

How much more RMDs are we talkin’ for the traditional method? With the TPM method Bill and Barbara will have to take $1,750,752.54 in RMDs, and with the traditional method they will have to take $5,894,467.45. So Bill and Barbara will have to take over $4M more required distributions with the traditional method than the TPM method!

How much more taxes will Bill and Barbara have to pay as a result? With the TPM method Bill and Barbara will pay $248,944.73 in taxes, and with the traditional method they will pay $1,236,707.56 – nearly 5x more in taxes! So Bill and Barbara will save about a million dollars in taxes with the TPM method!

Another interesting note about the above “difference” plot: you can see how the PostTaxTotal drops below zero towards the end, because with the traditional method you’re taking much higher RMDs (which is also why the PreTax and PreTax457b lines level out) and those larger withdrawals are put into the post-tax account (after paying hefty taxes), so eventually the post-tax account for the traditional scenario overtakes the post-tax account in the TPM scenario. Which is fine – you’ll still have far more total assets, because the Roth account for the TPM scenario is dramatically higher (ideal for estate planning actually). And unfortunately an RMD cannot be rolled over to a Roth via a conversion.

A diagram of this example:

Code

If you’d like to plug in your own values to this tool to see how RMDs will impact your retirement, you can download the code or modify and run the embedded Python interpreter below.

You can also of course tweak the code itself to your heart’s content. Especially if you’d prefer to change the look of the plots for any reason. 

Modify the user inputs section at the top as desired, then hit the Run/Play (sideways triangle) button to generate the plots. To go back to the script to make any changes, hit the Pencil icon. If you want the text larger, hit the hamburger menu button, then scroll to the bottom to see larger font options. In that same menu you can also Full Screen the window, and other actions.

Future Work

The above plots and example scenarios show how the TPM method can greatly reduce your RMDs and thus total taxes by taking advantage of your standard deduction every year to shift money from pre-tax accounts to post-tax accounts.

The main next question in my mind: instead of striving for a $0 tax bill until age 72 (as is the default in the TPM method), could it be worth it to exceed the standard deduction and thus pay a small amount of taxes earlier in your retirement to further reduce your pre-tax account balance and thus reduce RMDs and taxes after age 72?

That’s the question I plan to tackle next, and I’m very excited to figure that out. 

Conclusions

The TPM withdrawal method has a lot of advantages over the traditional withdrawal method, but prior to this post I hadn’t shown one of its biggest advantages: lowering RMDs and thus your tax bill. And in the end, this might be the biggest advantage of all actually.

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