IRA required minimum distributions (RMDs) mess up the financial plans of many IRA owners and create a new set of problems for them. But you can overcome these problems.
While the tax code requires IRA owners to begin minimum annual distributions after age 70½, most IRA owners don’t need the money to pay their living expenses, according to the recent RMD Options Study conducted for Allianz Life Insurance Company. The study found that 80% of respondents ages 65 to 75 believe they won’t need all of their RMDs to pay for daily living expenses.
RMDs create at least two problems for many IRA owners. Taxes, of course, are the first problem. RMDs from traditional IRAs must be included in gross income and are taxed as ordinary income. A high-income taxpayer can pay a third or more of the RMD in federal and state income taxes, while lower-bracket IRA owners still pay a significant portion of the RMDs in taxes.
RMDs can trigger additional taxes. They increase adjusted gross income (AGI). A higher AGI can trigger higher taxes on Social Security benefits, increase the Medicare premium surtax and cause other tax boosts.
The second problem with RMDs is you have to decide what to do with distributions that exceed your spending needs. About 71% of the survey respondents say they’d like to fund a financial product that offsets some of the taxes from the RMD. More than half of the IRA owners say they plan to leave the IRAs and a portion of their other savings as a legacy. They don’t need or want to spend the RMDs and hope to invest them to increase their value.
Fortunately, IRA owners can choose from strategies that reduce the problems of RMDs. It is best to start planning to reduce RMDs as early as possible. The RMD schedule increases the percentage of the IRA that is distributed each year. Many IRA owners find that in their late 70s, the income taxes and forced cash flow begin to be significant problems. I call this the IRA Waterfall. The earlier you plan to reduce RMDs, the more flexibility you will have and the lower the cost will be.
Here are some ways you can deal with the IRA Waterfall.
Qualified charitable distributions.
The qualified charitable distribution (QCD) remains the best strategy for owners of traditional IRAs who are charitably inclined. You direct the IRA custodian to transfer money from your IRA to a charity you select. Or the custodian can give you a check payable to the charity.
The charitable distribution counts toward your RMD. Yet, it isn’t included in your gross income, and you don’t take a deduction for the charitable contribution.
If you’re making charitable contributions anyway, the QCD often is the best way for those over age 70½ to make them. The QCD can be used only for gifts up to $100,000 each year. More details are in our May 2016 issue.
In a longevity annuity, also known as a deferred income annuity, you deposit money with an insurer. The insurer promises to pay you a fixed annual amount beginning at a time in the future you select. The payments begin no sooner than two years after you deposit the money and must begin by age 85.
The IRS has ruled that qualified longevity annuity contracts (QLACs) reduce RMDs, because the amount invested in one doesn’t count as part of the IRA balance when computing RMDs. Putting a portion of an IRA in a QLAC effectively delays the RMDs on that part of the IRA. You can invest up to the lower limit of $125,000 or 25% of your IRAs in longevity annuities. More details are in our October 2015 issue.
Reduce your IRA early.
Most of us learned early that a key tax planning principle is to defer taxes whenever you can. That was good advice in the past, but now it isn’t the best advice in all situations.
Years ago, I ran the numbers and concluded that many people would benefit by reducing their IRAs earlier than they needed to or were required to do. They should take money out of the IRA, pay the income taxes and invest the after-tax amount in a taxable account.
This strategy makes the most sense when you expect income tax rates will be higher in the future, but it also can make sense when your tax rate is likely to remain the same or even decline a little.
IRA distributions are taxed as ordinary income. If your IRA is invested to earn long-term capital gains or qualified dividends, you’re converting tax-advantaged income into ordinary income. Over the long term, it can be better to have the money in a taxable account than continuing to compound in the IRA eventually to have it taxed as ordinary income.
Your heirs also are likely to be better off inheriting the taxable account. When a beneficiary inherits a traditional IRA, the distributions from the IRA are taxed to the beneficiary just as they would have been to you. The beneficiary really inherits only the after-tax amount.
But when other assets are inherited, the heirs increase the tax basis to their current fair market value. They can sell the assets and owe no capital gains taxes. All the appreciation during your lifetime escapes taxation, giving the heirs the benefit of the full value of the assets. It’s better for loved ones to inherit taxable accounts than traditional IRAs of the same value and even of greater value, to a point.
Convert to a Roth IRA.
Even better than reducing your traditional IRA early is to convert it to a Roth IRA. Your heirs would inherit a tax-free account instead of a taxable account. They’ll have to take RMDs during their lifetimes, but the distributions will be tax free. All the RMDs to beneficiaries do is prevent additional tax-free compounding of income and gains on the distributed amounts.
We’ve covered Roth IRA conversions in the past. They make sense in a number of situations. If you’re planning to leave an IRA to children or grandchildren, often the best move is for you to pay the taxes now by converting at least part of it to a Roth IRA for them to inherit. More details about how to decide when to convert an IRA are in our May and June 2018 issues. This could be an especially good time to convert an IRA. See the article following this one for details.
Set up a charitable remainder trust.
You create a charitable remainder trust (CRT) by having a lawyer draft the document and then transferring property to the trust. The trust pays you (or you and your spouse) income for life (or whatever other period you designate), and then the property remaining in the trust goes to a charity or charities you designate.
You can fund the trust by taking a distribution from an IRA and donating it to the CRT. If you itemize expense deductions, you’ll receive a charitable contribution deduction for the present value of the amount the charity is estimated to receive in the future. Tables issued by the IRS are used to calculate the deduction. The older you are, the greater your deduction will be.
Many large charities will manage the investments and administer the CRT for little or no fee when they are at least one of the beneficiaries. The CRT ensures you a lifetime stream of income and can reduce the tax bill on the RMDs.
Establish a family bank.
We’ve already discussed why it’s better for heirs to inherit a taxable account than a traditional IRA. It might be even better for them to inherit a life insurance benefit.
The life insurance benefit is income-tax free. In addition, the amount they will receive is guaranteed. The value of an IRA or taxable account will fluctuate with investment returns and distributions. But the life insurance benefit is set when you buy the policy.
You can take RMDs each year, pay the taxes, and use the after-tax amount to pay premiums on a permanent life insurance policy. Or you can distribute the IRA in a lump sum and use the after-tax amount to make a lump sum premium payment. The benefit from the policy is likely to be the same amount or higher than the value of your IRA, depending on your age and health.
You maximize the policy’s benefit when you and your spouse buy a joint life, or survivorship, policy. You have access to the policy’s cash value account in case you need additional income. Your heirs can be named as beneficiaries and inherit a share of the policy directly. Or you can have the benefit paid to a trust.
The trustee manages the benefit and makes distributions to the beneficiaries according to the terms of the trust agreement. This is a flexible strategy that can be adapted to meet your needs and goals. To discuss how to structure this arrangement for your needs, I recommend contacting David Phillips of Estate Planning Specialists at 888-892-1102.
These are the main strategies you can use to reduce the taxes on RMDs and reposition your IRA so that it provides a greater after-tax benefit to your heirs without permanently increasing your tax bill the way RMDs do. For additional strategies and details, see our September 2016 issue.