When you turn 70½ you are required to begin taking at least minimum withdrawals from IRAs, 401K, 403b and other tax-deferred retirement accounts. These withdrawals start at roughly 4% of the previous year-end account balance and increase with age.
Some people who have relatively good Social Security income and perhaps pension income or money coming in from rental property don’t need the IRA withdrawal to supplement their income. But the IRS levies stiff penalties (50% of the amount that was to be withdrawn) if you fail to make annual required minimum distributions (RMD).
You have to begin withdrawing from the retirement account and paying ordinary income tax on the amount withdrawn. However, there are several ways to keep this money working toward your financial goals. You do not have to withdraw cash and either spend it or put it in the bank earning nothing.
Here are four options when you don’t need withdrawals from your IRA/401k to meet your spending needs.
1. Withdraw holdings, not cash
If you prefer to keep your money invested you can simply move a holding large enough to satisfy the requirements of the RMD from an IRA to a taxable individual or joint account. This doesn’t work from an employer plan since they typically only distribute cash. This is another benefit of executing a rollover of your employer retirement plan to an IRA.
You simply have to instruct the custodian of your accounts (usually by submitting an IRA distribution form) to move the desired amount from the IRA to your taxable account. If your RMD is $6,000 and you own $25,000 of ABC stock or XYZ mutual fund, you provide instructions to move the necessary number of shares to satisfy the $6,000 distribution.
Even though the position isn’t liquidated, you will owe ordinary income tax on the amount of money moved. Therefore, you will need to have enough money set aside in cash to pay the tax due (either as part of quarterly payments or when you file your return by April 15 of the following year).
When you move a position to a taxable account, the value of the position on the date of transfer becomes the cost basis within the taxable account. The holding is shifted from an ordinary income asset to a capital-gain asset.
The most tax-efficient way to do this is to transfer holdings that do not pay income (i.e., non-dividend paying, growth-oriented stocks or exchange-traded funds). This way, the holding defers taxation in the same way the IRA holding would have, not incurring any tax until it is sold, or possibly even receiving a step up in cost basis at death, resetting the amount of taxable gain.
2. Convert to a Roth IRA
There is currently no income limit or earned income requirement that restricts people from converting money (or holdings) in tax-deferred retirement accounts to a Roth IRA. While Traditional IRAs and Rollover IRAs require minimum distributions after age 70½, Roth IRAs do not require annual distributions. Future growth in a Roth IRA is also tax free, even for your heirs, although the beneficiary would have to start making annual minimum withdrawals.
Especially if you don’t expect to need some of your investment savings for your own retirement income, converting to a Roth IRA may be particularly beneficial to the next generation.
To perform a conversion, it is necessary to pay ordinary income tax on the amount converted (it can be any amount, it does not have to be all of an account). Accelerating taxation is a high hurdle for many people to get over. But in the right circumstances, the long run tax benefits will outweigh the upfront tax costs. Some people are serial converters, filling up their current tax bracket each year but not converting so much that the move shifts them into a higher tax bracket.
This process is another reason why it’s helpful to move 401k or other employer plan assets into a Rollover IRA.
3. Give the amount of your RMD to charity
If you have a cause or organization you would like to support, you can donate up to $100,000 of your RMD directly to a qualified charity. You won’t owe any ordinary income tax on the amount donated. The charitable organization receives the full benefit of the untaxed gift.
This transfer of money (or a specific holding) must move directly to the charity without being received by you in any form to qualify as untaxable. It’s much more beneficial than receiving the IRA distribution, having it added to your adjusted gross income for the year and then turning around and gifting essentially after-tax dollars.
Better yet, your donation is 100% deductible, helping lower your taxable income. And by keeping your adjusted gross income down, you may qualify for additional tax deductions and possibly be able to avoid the new Medicare surtax that adds an extra 3.8% to your ordinary income tax bill.
4. Use the RMD amounts to purchase life insurance
This is a more complicated scenario that is limited mostly to people who are in relatively good health. If you are insurable and do not need the money from the RMDs, you could use this amount to fund the annual premium of a life insurance policy (likely a survivorship or second-to-die policy). Much like the Roth IRA conversion, this strategy requires you to get over the upfront cost to get to a possibly better long-term outcome.
Life insurance death benefits are tax free to the beneficiary. The policy can be structured to pay out a death benefit that significantly exceeds the after-tax benefit that would be received as the beneficiary of an IRA instead.
Plus, since you would theoretically be using only the RMD to pay the insurance policy premium, the remainder of the IRA would continue to be invested and earmarked for a beneficiary.
This strategy is subject to a lot of ifs and requires the convergence of tax planning, investment management and estate planning. It’s a strategy that might be helpful in one area but not so wise for another aspect of your financial planning. You’ll need to take the time to work with your advisor to figure out whether it is a fit for you.
Depending on your financial planning objectives, these strategies can reduce taxation, get more money to heirs or charities and keep your investments working for you.
If you would like to discuss how any of these options best fit your situation, please let us know.
~ Gary Brooks, CFP® — Brooks, Hughes & Jones Wealth Advisors – Tacoma, WA