2021 RMD Scenario

[brenda4672]

Had  the following question posed to me from a financial advisor to my tax client and I'm just not sure how to answer it. I have an idea of what to tell them but any sort of enlightenment would be appreciated. Thanks!

"With the law change removing the age limit on Traditional IRA contributions, I should be having you take your 2021 RMD this year, but withhold zero taxes from it, and then essentially deposit the same funds back into your IRA as a 2021 deductible contribution.  Your RMD this year is $6,288.29, so we could essentially fully negate the taxation of it by depositing back in."

[IRonMaN]

Ignoring any other potential pitfalls in the scenario, are they still earning wages that would allow them to make an IRA contribution?

[qbteachmt · Accepted solution]

"and then essentially deposit the same funds back into your IRA as a 2021 deductible contribution."

Don't confuse distribution, rollover and transfer. A contribution has absolutely no bearing on the source of funds.

Qualifying to make that deduction and qualifying to make an IRA contribution, are each/both subject to yet other separate things that have no bearing on the source of the funds you intend to use for that contribution.

You have to have earned (wage or working) income to be able to make a contribution, and if you cannot afford to fund that contribution from funds on hand, you then could have sold a kidney, drugs, or taken the RMD as the source of the funds to deposit. That RMD doesn't affect its taxability the way a transfer or rollover might. The RMD is a type of taxable cash inflow, no matter how it gets used.

There also is no direct correlation between the RMD withholding and the Taxes owed. Each item stands separately. The RMD is taxable; period. The deduction for the IRA contribution might or might not wash away the same amount as the RMD creates. Their 1040 has more than just these two activities, and must have earned income at the least, as a third activity. The withholding on the RMD is nothing more than a prepayment of projected tax liability, the same as wage withholding isn't tax on wages; it's a computed projection on the entire 1040 collected through wages, if the TP chooses this method.

You can always choose to have no withholding and pay quarterly estimates.

[brenda4672]

Thank you, I thought so just needed to make sure I had the correct response.

[George4Tacks]

I would also engage in a conversation about ROTH IRA contribution and/or rollover. This person is old enough to have an RMD (assuming this is not an inherited IRA which would start another conversation), so they have a shorter period of playing this game. There are also new rules on speed of distribution of inherited IRAs that also should be looked at. I hate simple questions as they also lead me to many more "simple" questions that seem to have complicated answers.

[qbteachmt]

"I hate simple questions as they also lead me to many more "simple" questions"

I agree. Just on the surface, there are some assumptions I would make for input in this type of counseling. For instance, there are better ideas than what that financial advisor offered:

They mention the new rules, so this assumes the person is over 70 and still working, even though also taking RMD, so likely 72 or older. That RMD isn't relatively large, which allows you to back-calculate the amount in the IRA. If the person doesn't "need" the RMA, as indicated by the question that came up, then I would take the RMD, put into Roth as much of this year's wage provision as can be afforded and would be allowed, with the RMD being a net (allowing the withholding so that the tax hit isn't a surprise in April). I would also consider looking at conversions splitting it for 2021 and for 2022, spreading it out to avoid IRMAA, and to spread out the tax hit on the conversion into different tax years.

This accomplishes not needing to take RMA, when the conversions are done. And, if the person doesn't really need the IRA funds for 5-7 years at a minimum, it is likely the tax on the conversion will pay back by earnings/growth in that timeframe, if this is invested well. And then we don't need to worry about RMDs. If they keep working, the deductibility of new Trad IRA isn't as important as new contributions going into the Roth. Because if you ware going to rely on growth and gains and earnings, who wouldn't want it to be tax free?