TRUE TAX TIME TALES - IRA WITHDRAWALS

Here are two instances from the recent tax-filing season that concern excess withdrawals from an IRA and the tax consequences, federal and state (NJ), thereof.

Both taxpayers are retired and over age 70½, so they are receiving annual RMDs (Required Minimum Distribution) from their traditional IRA investments.

Client A is a widow with income from Social Security, her IRA, a state pension, and interest, dividends and capital gains.

Client B, who is married, has income from Social Security, his IRA, a small corporate pension, taxable interest, dividends and capital gains, and a large investment in tax-exempt municipal bonds that generate substantial supposedly tax-free income.

Normally Client A would take the RMDs from her various IRA accounts, and Client B would take a distribution of the earnings from his IRA investments, which was slightly more than his RMD.

In 2013 both had investments in their traditional IRA come due - a CD for Client A and a corporate bond for Client B - resulting in excessive cash in the IRA.  Both took significant cash withdrawals from their traditional IRAs that were in excess of their RMDs for specific reasons.  For Client A the excess amount was $43,000+ and for Client B the excess amount was $35,900.

Here is what I explained to Client A –

“Oi vey!

The $43,413.00 extra IRA withdrawal increased your AGI, so it decreased the amount of your medical and miscellaneous expense deductions. The $43,413.00 added $47,547.00 to your net taxable income.

Plus it pushed you well into the 25% tax bracket, and caused your long-term capital gains and qualified dividends to be taxed at 15%. Without this additional income they would have been taxed at 0%.

It cost $12,164.00 in additional federal taxes, but only $4,341.00 (10%) was withheld - leaving a shortage of $7,823.00.

It also reduced the amount of medical expenses I could deduct on the NJ return - the $43,413.00 added $44,281.00 to your net NJ taxable income. It cost $1,121.00 in NJ state income taxes, and nothing was withheld for NJ.

So the total tax cost of this withdrawal was $13,285.00 - or about 31%.”

But there was more –

“Plus it kicked your actual gross income to over $100,000 – much more than the $80,000 income threshold to qualify for the Property Tax Reimbursement (PTR) {A special NJ state program that reimburses seniors and the disabled each year for the increase in property taxes – rdf} for 2012 AND 2013 (you need two consecutive years of under $80,000 to qualify). You will not get a PTR check for 2012 or 2013.”

So the actual cost of the excess IRA withdrawal was increased by over $1,000.

Client B’s additional IRA withdrawal also reduced his deductible medical expenses – so the additional taxable income went from $35,900 to approximately $38,600.  In the past he did not have to worry about the dreaded Alternative Minimum Tax, so his portfolio included a substantial amount of interest from “private activity bonds”.  As a result, the increased IRA withdrawal caused B to become a victim of AMT.  The bottom line was about $6,300 more in federal income tax. 

Luckily Client B lives in a state that does not have an income tax.

Because neither client had a “tax basis” in their IRA investments the amount of the IRA withdrawals were fully taxable as ordinary income.

Neither A nor B had to take the money from their traditional IRA accounts.  Both could have come up with the same amount of cash by selling available current investments – mutual fund shares for Client A and tax-exempt bonds for Client B.  At most there could have been a capital gain on the sale – which would have been taxed at the 0% rate on the federal level.

Both taxpayers were already being taxed on the full 85% of their Social Security benefits.  But for those who are not - for each additional unnecessary $1,000 IRA withdrawal they could be taxed on $1,850, making an unnecessary IRA withdrawal even more costly.

Obviously neither A nor B consulted me before taking the additional IRA withdrawals.

What can we learn from the experience of these two clients? 

For one, do not take money in excess of your RMD out of an IRA when you have an alternate source in “current” investments.

And, of course, do not take a substantial excess withdrawal from your IRA without first talking to your tax professional.  If A or B had called me before withdrawing the money I could have worked up a projection and showed them just how much the IRA withdrawal would cost.

TTFN