Possibly better to pay RMD penalties than to take RMDs?

Question

Could it ever be advantageous for a wealthy retired person over the age of 70-1/2 with significant taxable investment income to intentionally fail to take a Required Minimum Distribution (RMD) from an IRA and just pay the 50% penalty that is imposed for failure to take the RMD? The penalty could be paid from non-IRA funds, thereby allowing the IRA funds to continue to grow tax-free.

For example, if income taxes for the wealthy were to increase due to changing political ideologies, a 50% penalty in lieu of taxes might be a bargain. Currently (2019) the top federal income tax rate is 37%. The top California state income tax rate currently adds another 12.3% for a top marginal tax rate of 49.3% for taxable income in the $500K range. A Quora post says that the IRS reported 898,415 tax returns with an AGI over $500K in 2011, so some taxpayers are probably in this situation already.

Even a wealthy resident of a state with moderate income taxes could benefit from paying the penalty if maximum federal tax rates ever return to historical levels. The top federal tax rate was 70% as recently as 1980, and it was an unbelievable 94% during WWII. Historical tax rates here.

So am I missing something or could this be a viable strategy when a wealthy person doesn’t need the income from their IRA and would rather let it grow tax-free until the end of their life, to be left to individual beneficiaries in lower tax brackets?

Answer 1

This might work if you die in your seventies. But, since the distribution period decreases every year (percentage increases), if you live into your late eighties, you will be accessed the penalty over and over for the amounts you should have taken.

Assuming that your tax bracket soars to 70%, a modest growth of 3%, and whoever inherits this IRA pays zero taxes (not true), this plan only works up to age 83. If you live longer than that you pay an enormous amount of penalties.

Answer 2

I suppose it's possible that the penalty could be less that the overall marginal tax rate, but if tax rates ever do get that high, I suspect that people in that situation - meaning extremely high incomes - will instead do something with the RMD to lower the tax burden, such as giving it to charity or funding an endowment.

In other words, someone making $500k+ might not need their RMD and would rather give it away than lose half of it.

Answer 3

Interesting idea - but unfortunately it doesn't work. Your logic (tax rates next year are going to be higher than this year) actually would require you to accelerate ALL distributions, required or otherwise.

Just as an illustration, assume you have an RMD of $1,000, tax rate this year of 50% and 80% for next year. Also assume that you can make an amazing 20% annual return, inside or outside the retirement account.

If you take the RMD this year, you pay 50% or $500 tax this year, and net $500 after tax; next year earn 20% or $100 on that $500 after tax amount and pay 80% or $80 on the second year income. So at the end of the second year, your after tax net is $520.

If you only take the RMD in the second year, you first pay 50% penalty or $500 out of your own pocket (which is already after tax). The unpaid RMD now earns the same 20% or $200 inside the retiremenet account and at the end of the second year you take the distribution of $1,000 (or actually more), and pay 80% or $800, and net $200. You still have another $200 inside the retirement account, but when that too comes out, it will also be subject to 80% tax or $160, for a net of $40. So your total after tax net is $200, less the $500 penalty, plus $40 - for a total of -$260.

As I said, if you expect a significant increase in tax rates, you actually want to acclerate income recognition, not delay it and defintily not pay a 50% penalty for the privilege...