Uncle Sam Making it Rain on July 1, 2016
It’s not a secret – a lot of people made a lot of babies following the end of World War II. Who can blame them? On July 1, 2016 those oldest “baby boomers” turn 70½ years old. Who cares? The federal government. Why? Because tax-deferral for trillions of dollars held in retirement vehicles is about to end. IRAs and 401(k) plans – the quintessential tax deferred vehicles. IRAs and 401(k)s were introduced in the 1970s and came into broad circulation during the 1980s. The widespread adoption of these tax-saving vehicles was in large part fueled by our nation’s shift from defined benefit plans to employer-sponsored retirement plans.
These vehicles are appealing because they provide two big income tax benefits: 1) taxpayers receive an immediate income tax deduction equal to the amount of money contributed to the plan (subject to certain limitations); and 2) investments within the plan grow tax free. This differs from a Roth IRA, which is funded with after-tax dollars. These devices form the backbone of many American retirement plans.
Like all good things, these government-sanctioned tax shelters eventually come to an end. At age 70.5, the retiree must begin withdrawing money from the plan, which is known as a required minimum distribution (“RMD”).[1] The retiree becomes subject to income tax that has probably been deferred for decades. The penalty for failing to take a RMD is equal to 50% of the amount that was required to be distributed. That is pretty good incentive to comply with rules, since money in the retirement account will inevitably find its way to either the retiree or the government.
Why does any of this matter? Baby Boomers were the first generation to build their retirement plans around traditional IRAs and 401(k) plans. And the oldest boomers, those born during the first six months of 1946, turn 70.5 on July 1, 2016.
The result is staggering. Currently, traditional IRAs and 401(k) plans hold more than $14 trillion. Assuming a 20% marginal tax rate, the feds can expect to receive $2.8 trillion of tax revenue from RMDs.[2] The feds obviously do not receive this amount at once; rather it will be realized over several decades.
Moreover, investors are inclined to keep their money invested in these vehicles for as long as possible due to the tax benefits. For example, retirees can purchase qualified longevity annuity contracts, which are held in the retirement account, but are excluded for purposes of calculating the RMD. To minimize tax avoidance, these contracts are limited to 25% of the portfolio value, or $125,000, whichever is greater.
Regardless, Uncle Sam has yet another reason to celebrate this Independence Day.
— By Michael S. Cooper, Esq., Barnes Law
Michael Cooper is an associate attorney with Barnes Law, and is licensed to practice law in California.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] The RMD amount is a function of the total tax-deferred savings balance at year-end and the number of years the retiree is expected to live. Curious how long the feds expect you to live? See Table III of IRS Publication 590-B, which includes a RMD worksheet.
[2] Present value analysis omitted