I know you hate them. So why pay them? RMDs, also known as Required Minimum Distributions, are the bane of many a retiree. Once you reach age 70.5, the IRS is through waiting and forces you to take withdrawals from your traditional IRA accounts. Failure to do so incurs a steep 50% penalty.
Now the IRS isn’t doing this just to be sadistic; the government desperately wants that money that has quietly been sheltered from taxation. So the methods by which you can avoid RMDs are few and very specific. Here are your best options:
1 – Convert to a Roth IRA
Roth IRAs are not subject to RMDs, but, of course, there’s a catch: Upon converting your traditional IRA to Roth, you’ll pay tax at your marginal income tax rate. As a result, timing can be critical. Things to consider:
Is the market up or down? It may make sense to convert when the market is down so you’re converting less and hence paying less in tax. Remember, the amount converted counts as ordinary income, so keeping the taxable amount low is key.
How much other income will you claim this year? Generally speaking, it would be a bad idea to convert so much that you send yourself into a higher tax bracket, so being mindful of your other income is important.
Where do you think tax rates are going in the future? If you think President So-and-so or Congress is going to jack up rates in the future, it might make sense to do some converting now when tax rates are perhaps lower.
2 – Use a QLAC
A Qualified Longevity Annuity Contract (QLAC) is a very specific deferred annuity in that it’s the one place you can put IRA money and not have to pay RMDs. In 2014, the Treasury Department ruled you could place up to $125,000 into a QLAC.
But understand that a deferred annuity, by definition, must provide income sometime in the future, generally between 10 and 20 years. So eventually, the money will begin coming out of the QLAC and be subject to RMDs. So the QLAC is a temporary, not permanent, reprieve from the mandatory tax.
The other thing to be mindful of is that the rate of return on deferred annuities is pretty low. You’ll have to weigh carefully if avoiding RMDs in a low-yield investment is more beneficial than being subject to the tax in an investment with a better return.
3 – Contribute to Charity Instead
At the end of 2015, President Obama made Qualified Charitable Distributions (QCD) permanent. The provision allows those compelled to take RMDs to do so tax-free, up to $100,000 per year, as long as the distribution is made direct to a qualified charity.
Making a QCD is a great way to support the cause of your choice tax-free, but, of course, the money donated is gone forever. This option works well for IRA owners who don’t need the money for their own retirement needs.
4 – Buy Life Insurance
Speaking of IRA owners who don’t need the money, there’s another interesting option to consider if the objective is to maximize inheritance for your beneficiaries: Use your RMD to buy life insurance.
Let’s be clear; this strategy does not avoid your RMD obligation. Instead, it seeks to turn the tables on the IRS by turning a taxable event into a tax-free benefit for your heirs.
For example, let’s assume a married couple is obligated to take a $5,000 RMD. Assuming their marginal income tax rate is 20%, they’d have $4,000 left over after withholdings. Let’s say we decide to insure the husband with that money. If he’s in good health, that might buy a $150,000 life insurance policy. When he dies, that $150,000 is distributed tax-free. That money could go a long way toward replacing his widow’s lost pension or Social Security benefits. But if she won’t need the money, they could direct it instead toward paying off a home or college tuition for a child or grandchild.
Is that a good deal? Think about it, if our couple just stowed that $4,000 into their checking account, how many years would need to go by before those distributions total over $150,000? All else aside, it would take over 37.5 years!
A little planning goes a long way. Contact us today to learn more about applying any of these solutions.
Investment Advisory Services are offered through Arcadia Wealth Management, LLC, a registered investment adviser. Insurance products and services are offered and sold through Arcadia Financial Group, LLC and individually licensed and appointed insurance agents. Arcadia Financial Group, LLC and Arcadia Wealth Management, LLC are affiliated but separate entities.