We wrote last week about some of the pros and cons of buying a new home, and this week we encountered the question above in relation to a couple who are retired and are also subject to Required Minimum Distributions (RMD) from their IRAs. (For those who may be unaware, at age 72, you must start taking a certain amount from your IRAs every year, until your death.) In this particular case, the clients were looking at a new home purchase and were interested in a large distribution from their IRA to fund a down payment.
When questions about purchasing a new home, a new car, or other larger item, the conversations with our clients go something like this:
“Yes, you do have a significant balance in your IRA that could pay for __________. But there are some other factors that we would like to review with you.”
What are they?
First and Foremost: What are the tax consequences of taking a large withdrawal from an IRA?
As most people realize, virtually every dollar taken as a distribution from an IRA (or similar) is fully taxable in the year of the distribution. What they often do NOT realize is that an extraordinary distribution can be enough to put them in a higher tax bracket: So, in the case of our client’s question this week, the amount requested was enough to move them from a 15 to 20% effective tax bracket, with a resulting $50,000 in additional taxes due over the previous year. And it doesn’t stop there:
- They would need $50,000 to pay the tax on the distribution, and then they would have to pay tax on the amount withdrawn to pay the tax!
- So, they could add another $10,000 tax hit the following year, and so on.
Once we started adding all of that up, they began to see that their home purchase might not be worth an additional $60,000 on top of the asking price.
Second Consideration: IRMAA, or Income-Related Monthly Adjusted Amount for Medicare Premiums. IRA distributions function as an increase in your taxable income for the year they are taken. Annual income or MAGI on your tax return from two years ago is used to determine the amount of premiums you pay for your Medicare Part B. The IRMAA income brackets for a joint tax return in 2021 are:
- $176,000 or less: $148.50 per month (this is the standard amount)
- Up to $222,000: $207.90 per month
- Up to $330,000: $386.10 per month
- $330,000 to $750,000: $475.20 per month
- $750,000 and up: $504.90 per month
For the particular couple in my example, in a couple of years, it would have increased their Part B Premiums to $386.10 per month…for each of them! I calculated an estimated $5700 total in increased costs two years from now, just for their Part B Premiums.
At this point, our total tax dollar hit for one distribution is $65,700!
Are there any alternatives?
Fortunately, there are a couple of reasonable options that would enable this particular couple to achieve their goal.
- Set up monthly payments:
Instead of taking a lump sum, it was more tax-efficient for the couple in our example to obtain a loan at a historic low rate of less than 3% and set up monthly payments from their IRA to cover their loan costs.
We have done this many times with our clients, especially with car loans, but it also works well for real estate loans. So yes, they are paying taxes on the amount of money that is distributed, but at a much more reasonable $40,000 per year, which won’t increase their tax bracket, nor their IRMAA, and it will cover a large portion of the RMD that they have to take out anyway. We call that a WIN!
- IRA Distribution with 60-day Reimbursement:
This second option can be a bit more challenging but has the potential to work in this situation. The couple had originally intended to use their IRA distribution to make the down payment for their new house, so they would not have a contingency offer based on the sale of their current home. But because the real estate market has been moving as quickly as it has this year, their other option was:
a. Take the amount of the down payment from the IRA as they originally planned for the down payment, but:
b. Once their house sells, pay back the IRA with the sale proceeds. This can work really well, as long as they pay it back within 60 calendar days. It cannot go past that 60-day limit for any reason, or the full amount of the distribution will be taxable in the year it is taken. It also adds a layer of complication if the 60 days crosses into a new year, so it is best for it to all take place within the same year if possible.
We are big believers in finding ways to help our friends achieve their goals and dreams; we just want to help them do it without unintended consequences, i.e., punitive taxes in this case. Not only is the dream or goal important, but the enjoyment of it without regrets. Moral of the story: please check in with your advisors before making big, expensive decisions- it is our job to look out for your interests, and help you avoid the giant potholes that you may not see.