Don’t Let the IRS Decide Your IRA Strategies
Most people with significant assets in IRAs and 401(k)s let Congress and the IRS determine their spending and distribution strate- gies. That’s a big mistake that can cost them and their families quite a bit of money. Most people don’t begin taking money out of their qualified retirement accounts until the required minimum distribution (RMD) rules say they must, according to a J.P. Morgan Asset Management study produced in 2021 that used data from both the Employee Benefit Research Institute and accounts held at JPMorgan Chase of middle- and upper-middle class households with $300,000 or more in their retirement accounts.
As I discussed in last month’s is- sue, the RMD rules are a tax trap for many middle- and upper-middle class households. The longer distributions from traditional IRAs and 401(k)s are delayed, the higher the lifetime income taxes are likely to be for the owners and heirs. You need to let go of the idea that dis- tributions shouldn’t be taken until the government says you have to through RMDs. Congress set the rules for its benefit, not yours. As I reviewed last month, it’s not always a good idea to defer taxes for as long as possible. It is important in the retirement years to shift from the savings mindset to the distribution and spending mind- set.
Create a thoughtful spending and distribution strategy. Here’s an important finding from that J.P. Morgan Asset Management study. While most of the people didn’t begin distributions until required and took only the RMD amount, those who took distributions earlier tended to have more wealth than the median. I suspect that’s because they were more likely to have professional advisors and followed their advice. Over the years, I’ve run the numbers and found that because of the way RMDs are computed and especially because of the rules that heirs face, it can be very expensive to leave money in traditional qualified accounts too long. You can find the details in my books and some past issues of Retirement Watch.
The problem is especially acute for people who have sufficient income and other assets to pay most of their retire- ment expenses. They view the tradition- al retirement accounts as emergency savings or legacies for their heirs. The result is they and their heirs pay signifi- cantly more income taxes and Stealth Taxes than they need to do. To reduce those lifetime taxes and have more family after-tax wealth, con- sider repositioning traditional IRAs and 401(k)s. I’ve developed six strategies to consider.
The strategies are the most profitable when you expect income tax rates will be higher in the future, but also in other situations. You might find that one strategy or a combination of the strategies is best for you. Reduce your IRA early. Years ago, I ran the numbers and concluded some people should take money out of their IRAs before RMDs kick in and before they need the money to pay expenses.
They should pay the income taxes and invest the after-tax amount in a taxable account. Traditional 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 be taxed as ordinary income.
Your heirs also are likely to be bet- ter off inheriting the taxable account. Traditional IRA distributions to a beneficiary are taxed just as they would have been to you. The beneficiary really inherits only the after-tax amount. But when most non-IRA assets are inherited, the heirs increase the tax basis to 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. Convert to a Roth IRA. Probably the most used strategy today is to convert all or part of a traditional IRA to a Roth IRA. As you know, you pay a tax to convert the IRA by including the converted amount in gross income. But a conver- sion eliminates future RMDs for the owner and, after a five-year waiting period, distributions of income and gains are tax free.
Distributions to beneficiaries also are tax free, but most beneficiaries will have to distribute the entire Roth IRA within 10 years after inheriting it. I’ve discussed the pros and cons of IRA conversions and the best times to do conversions in my books and past issues, most recently in the December 2022 and September 2022 issues.
You can convert any amount you want, and there’s no limit on the num- ber of conversions you can do. Some people convert just enough each year to avoid jumping into the next higher tax bracket. Turn the IRA into permanent life insurance. Some people reap more benefits by repositioning their tradi- tional IRAs and 401(k)s as permanent life insurance. They take distributions from an IRA, pay the income taxes, and deposit the after-tax amount with the insurance company as life insurance premiums. Repositioning the IRA as permanent life insurance can have several advantages. The life insurance payout received by the beneficiaries is income-tax free.
The heirs benefit from the full value of the policy. The amount your loved ones inherit with life insurance is fixed by contract and doesn’t fluctuate with the markets the way an IRA balance can. With some types of life insurance, the benefit might increase over time. The life insurance benefit also is likely to be more than the current balance of the traditional IRA and almost certainly will be more than the after-tax value of the IRA.
Details will vary with your age, health and the type of permanent life insurance policy purchased. You might have lifetime tax-free access to part of the policy’s value through loans from the insurer using the cash value account as collateral. The loans won’t have to be repaid but outstanding loan balances reduce the final life insurance benefit. The loans might be interest free or have a very low interest rate, depending on the insurance policy.
You can take one large distribution from your IRA and use the after-tax amount to buy the policy with a single premium. Or you can take regular IRA distributions and pay annual premiums with the after-tax amount. I’ve discussed the life insurance strategy with some examples in past issues such as the April 2020 issue. You also can read more details in the special report by David Phillips available in the Special Report section of the members’ website, “The Bombshell Battle Plan.”
The IRS-to-Dynasty-Trust Strategy. This is a variation of the life insurance strategy. Instead of buying the policy, you set up a family dynasty trust and give the after-tax IRA distribution to the trust. The trust buys the policy and is the beneficiary with the trust beneficiaries being your grandchildren, children or both.
The trust can buy a joint and survivor life insurance policy covering both you and your spouse, which usually maximiz- es the permanent life insurance benefit per premium dollar. After both spouses pass away, the life insurance benefit is paid to the trust tax free. The trust invests and distributes the money according to the terms you set in the trust agreement. Distributions can be paid out to the beneficiaries on a schedule over the years, pay for specific needs, held until they reach certain ages or whatever other distribution plan you want.
Having the benefit paid to the trust instead of the individual beneficiaries substantially reduces the risk the money will be poorly invested or spent rapidly or frivolously. The charitable remainder trust. There are several ways to reposition the IRA as a charitable remainder trust (CRT) because CRTs are very flexible.
To provide a steady stream of lifetime income, you can take a lump sum distri- bution, pay the taxes and transfer the af- ter-tax amount to a CRT. The CRT invests the money and pays you (or you and your spouse) regular income for life. The income payments can be a fixed amount or can vary with the value of the trust each year. You decide when the trust is created. You qualify for a charitable contribution deduction in the year money is given to the CRT.
The amount of the deduction will depend on your age, current interest rates and the amount of income the trust will pay to you. After you and your spouse pass away, the assets remaining in the trust are given to the charity or charities you name when creating the trust. Your heirs can inherit other assets instead of the IRA.
When your primary goal is to provide for your children or grandchildren, you can name a CRT as beneficiary of your IRA with your children or grandchildren as the income beneficiaries of the CRT. After you pass away, the IRA balance will be transferred to the CRT. No income taxes will be due because the CRT is tax-exempt. The CRT will invest the mon- ey and pay annual income to its income beneficiaries. The beneficiaries will owe income taxes on most of the trust distributions just as they would have for IRA distributions.
Using the CRT allows you to set up the equivalent of the Stretch IRA that was end- ed by the SECURE Act. The beneficiaries won’t be required to take all the distribu- tions within 10 years. In fact, they won’t be allowed to do so. They’ll receive only the annual distributions from the CRT. The CRT trustee will professionally manage the assets and take care of all the accounting.
The trust assets also are protected from creditors of the beneficiaries. Most large charities and university endowments make it easy to set up CRTs. They’ll help draft the documents and then accept and manage the money for low or no fees as long as they are beneficiaries of at least half the trust remainder.
The charitable gift annuity. A simpler strategy is to reposition the traditional IRA as a charitable gift annuity (CGA). You take a distribution from the tra- ditional IRA, pay the taxes, and give the after-tax amount to a charity in return for its promise to make payments to you for life. Like a commercial annuity, the amount the CGA pays you varies with your age and current interest rates.
A CGA will make lower income pay- ments than a commercial annuity. The difference is a gift you’re making to the charity. When you transfer money to the char- ity for the CGA, you qualify for a chari- table contribution deduction equal to the estimated present value of the amount the charity eventually will receive. IRS tables using your age and current interest rates are used to calculate the charitable deduction.
Like the CRT, you can set up the CGA to benefit your children or grandchildren. The terms of the CGA are flexible. You can set them, so income payments aren’t made until the children reach a certain age or the payments are made for a period of years instead of for life.
