Barbara O'Neill: 403(b) Plans and Age 72

January 11, 2022

Guest post by Dr. Barbara O’Neill, CFP®, AFC®

Tax-deferred investments, including 403(b)s and traditional IRAs, don’t escape income taxes forever, but they do buy investors time. Sometimes many decades. Earnings are income tax-free until money is withdrawn, typically in retirement. Mandatory withdrawals, called required minimum distributions (RMDs), must begin no later than age 72. At that point, RMDs are added to taxable ordinary income.

Until then, untaxed earnings get added to untaxed 403(b) deposits and compound over time. Money grows faster in tax-deferred accounts (versus taxable accounts) and the gap between accumulated values in these two types of accounts widens over time. Eventually, however, it is time to “pay the piper” with RMDs and investors’ must shift focus from saving money to calculating how much is left after taxes.

This post includes basic information about tax-deferred investing, RMDs, and IRS tax regulations with respect to RMD tax payments and tax penalties. It also describes research findings about how many investors make RMD withdrawals and new life expectancy tables that debut in 2022. It concludes with six take-away action steps.

Tax-Deferral Take-Aways

Tax-deferred retirement accounts like 403(b)s enable investors to earn decades of compound interest on savings free of taxes. This has the effect of increasing returns and making assets last longer. This is illustrated below using a popular online calculator to compare taxable and tax-deferred investment growth on a $10,000 annual investment for 35 years for a taxpayer in the 22% tax bracket. Of course, this illustration does not take into account possible changes in a taxpayer’s marginal tax rate or tax laws.

Summary	Fully Taxable	Tax-Deferred
Current investment balance	$0	$0
Annual contributions	$10,000	$10,000
Number of years to invest	35	35
Before-tax return	8%	8%
Marginal tax bracket	22%	22%
After-tax return	6.2%	8%
Future account value	$1,172,951	$1,723,168
Future account value (after-tax)	$1,172,951	$1,421,071

RMDs and RBDs

403(b) plan participants can take voluntary penalty-free withdrawals as early as age 59½ but must begin RMDs upon reaching age 72. Some people need money early in retirement and withdraw money as soon as they are able. Financial planners often advise most people to wait until RMD withdrawals are required to earn an extra 12 years of tax-deferred compound interest.

Exceptions apply for affluent investors with large account balances and expected future RMD liabilities.

There are two “crunch” dates for RMD withdrawals: December 31 (the deadline for routine annual RMD withdrawals starting at age 72) and April 1 of the year after the year that someone turns 72 (the deadline for legally postponed RMD withdrawals). The latter date is referred to as the “Required Beginning Date” (RBD) and it applies only to a plan participant’s first RMD.

The downside to postponing the first RMD withdrawal to the RBD is the necessity to take two RMD withdrawals (the previous year’s withdrawal and the current year’s withdrawal) the following year, which could increase a 403(b) plan participant’s marginal tax bracket. After the first year, RMDs must be made by December 31 of each year.

Here’s a scenario…my scenario: I was born in 1952, which will make me age 72 in 2024. Therefore, my RBD is April 1, 2025.

Tax Topics

IRS rules for RMDs are very clear. To calculate RMDs, taxpayers take the balance in their retirement account on December 31 of the previous year and divide it by the appropriate divisor for their age. IRS life expectancy tables in IRS Publication 590-B provide the correct divisor to use.

Taxpayers can always withdraw more than the RMD amount but, of course, the money is taxed as ordinary income along with their other income for the year.

Here’s an example: Suppose a 403(b) plan participant turned 72 in 2021 and had an account balance of $100,000 on December 31, 2020. The divisor for RMDs taken in 2021 at age 72 is 25.6 and the RMD amount is $3,906.25 ($100,000 ÷ 25.6).

If the participant was a “super-saver” with a $1 million balance, the RMD amount is $39,062.50.

In my scenario, I plan to take my first RMD at age 72 to avoid the “double taxation” issue noted above. Therefore, I will use my 403(b) account balance from December 31, 2023.

RMDs are mandated by law and it is very important to get the calculation correct. If not, the IRS charges a penalty (excise tax) equal to half the amount that should have been taken out but wasn’t. For example, if the correct RMD amount is $5,000 and only $3,000 was withdrawn, the tax penalty is $1,000 (half of $2,000).

If the RMD is missed completely, the penalty is $2,500!

Research Results

Studies about RMDs have found that most retirees aren’t making withdrawals from tax-deferred accounts until they have to. In addition, many retirees use the RMD calculation as guidance for how much to withdraw, which financial advisors caution could leave a sizable balance in later life.

This is especially true for plan participants with pensions and/or annuities who do not need the entire RMD amount and tend to reinvest the “excess” in taxable accounts.

An article in the AAII Journal noted that many retirees “use the tax code as their withdrawal strategy.” In a 2020 survey of American Association of Individual Investors (AAII) members, 45% withdrew the minimum amount required by the tax code while 24% said they withdrew “only what’s needed for expenses.” Slightly less than 6% of respondents followed the popular “4% Rule” withdrawal strategy.

What’s New in 2022?

Updated IRS life expectancy tables to calculate RMDs go into effect on January 1, 2022 for RMD withdrawals in 2022 and beyond. Life expectancy divisors are a bit larger, which means RMD amounts are slightly smaller.

This change was made to help taxpayers retain their tax-deferred savings and postpone taxes a bit longer to enhance financial security in later life.

Suppose a 403(b) plan participant turned 72 in 2022 and had an account balance of $100,000 on December 31, 2021. The divisor for RMDs taken in 2022 at age 72 is 27.4  and the RMD amount is $3,650 rounded ($100,000 ÷ 27.4).

If the participant was a “super-saver” with a $1 million balance, the RMD amount is $36,496.35.

These amounts are $256.25 and $2,566.15 lower, respectively, than the RMD amounts for 2021 shown above.

Three (More) Tidbits

• Combined Calculations- Some plan participants have multiple 403(b) plans from work for different employers. Taxpayers with more than one 403(b) are allowed to combine RMDs from their multiple accounts and take a withdrawal from any account. Consolidation is also permitted for Traditional IRAs but not between 403(b) and IRA accounts.
• Automation Options- Some 403(b) plan participants have multiple tax-deferred plans including 457(b)s, traditional IRAs, and SEPs from self-employment. That is a lot to manage. Many experts recommend arranging automatic RMD withdrawals on a monthly, quarterly, or annual basis with account custodians. This helps create a retirement “paycheck,” smooths out market fluctuations, and avoids year-end stress and panic.
• RMD Planning- 403(b) participants are used to making deposits. Spending their money may seem like a foreign concept. What do you do with RMD withdrawals? The short answer is whatever you want. Options include living expenses, savings in a taxable account or Roth IRA (if you have earned income and meet the income limit), gifts to family and/or charities, and fun.

Six Smart Strategies

No. 1: Run the Numbers — Project your taxable income and deductions and “do the math” to determine whether to take your first RMD in the year you reach age 72 or at your RBD the following year. Then select the option makes sense tax-wise (i.e., where you will pay the least tax on RMD withdrawals over this two-year period).

No. 2: Don’t (Necessarily) Default to RMDs — Consider working with a financial advisor affiliated with your 403(b) plan provider, or a nearby certified financial planner®, (CFP®) to determine an appropriate amount to withdraw annually in later life. Financial advisors can run calculations to determine how long your money will last under different scenarios. These calculations can help inform future account withdrawals.

No. 3: Consider the Tax Impact of RMDs — Remember, 403(b) account balances cannot be held indefinitely. Think ahead to how RMDs will affect your income taxes. Depending on other sources of income, RMDs could push you into a higher marginal tax bracket or force you to have to pay IRMAA surcharges for Medicare Part B and Part D premiums.

No. 4: Review Your Tax Withholding — Ask your 403(b) plan custodian to withhold taxes on RMD withdrawals. Plan B is to send the IRS quarterly estimated payments. Make sure you send the IRS enough money to avoid under-withholding penalties. A good way to do this is to use the “safe harbor rule” and send the IRS at least 100% of your previous year’s tax (110% if your previous year’s adjusted gross income was more than $150,000).

No. 5: Get Help, If Needed — Contact your plan provider, a CFP®, and/or a tax preparer if you have questions about RMDs, particularly at age 72, where there are new “process steps” and tax concerns. Financial advisors can help you minimize tax consequences and develop plans to reallocate money that is withdrawn.

No. 6: Pay Attention — Prepare for future RMD changes…again. Just during the past two years, RMDs were waived for COVID-19 (in 2020) and a new life expectancy table was developed. Government policies could change again. Already, there is chatter about gradually raising the age for RMDs to age 75.

In Summary

A portion of your 403(b) plan is not yours to keep. Uncle Sam will eventually claim it. Take the time to learn about RMDs and their impact on your taxes and develop plans for the future use of this money.
 

This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.

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