Retirement is often associated with control – control over scheduling, travel, and leisure. However, beginning at age 70.5, some degree of retirees’ control is diminished by the individual retirement account (IRA) required minimum distribution (RMD). While there are worse fates than being forced to distribute your own hard-saved retirement funds, these distributions can create myriad issues when it comes to tax and estate planning. This is an area where your advisor can add great value, especially since more and more retirees are relying exclusively on 401(k)s and IRAs to fund their daily lives.
In this article, we’ll highlight three useful strategies to reduce or defer the tax implications of required IRA distributions. (Please note: These strategies are intended to be used with IRA accounts only, as there are different rules that govern 401(k) distributions.)
Roth conversions can be completed anytime, but they are particularly attractive for retired individuals under age 70.5. Prior to that age threshold, pretax money can be converted from a traditional IRA to a Roth IRA, reducing the asset base that is held to the RMD requirement. After age 70.5, individuals must take their annual RMD prior to doing a Roth conversion. The asset base and associated RMD will not be reduced until the following year.
We suggest discussing any potential Roth conversions with your wealth advisor and your tax professional, who can offer guidance on potential strategies to mitigate the associated tax liabilities.
Qualified Charitable Distribution (QCD)
Following legislation signed into effect in December 2015, individuals are able to donate up to $100,000 from an IRA account to a qualified charity each year. QCDs are excluded from adjusted gross income (AGI) and will offset the annual RMD. These charitable distributions can also be used to fulfill inherited IRA RMDs. It’s important to note that QCDs must be sent directly to the charity from the IRA. Taking possession of an RMD and then donating it to charity enables you to take a charitable deduction on your taxes, but it increases your AGI – thus impacting Social Security benefit taxation and potentially reducing other tax deductions.
However, with the passing of the Tax Cuts and Jobs Act of 2017, many tax filers may lose the ability to itemize their deductions. The new bill increased the standard deduction to $24,000 for married taxpayers filing jointly. If a household has deductions – including charitable donations – below the $24,000 threshold, charitable donations will likely provide no tax benefit. But for tax filers over age 70.5, QCDs are still an attractive option; since the strategy can be used to avoid realizing taxable income from tax–deferred accounts, there is no connection to deductions. If you are still interested in donating to a qualified charity and have concerns regarding your ability to receive any tax benefit, please do not hesitate to reach out to your advisor.
Qualified Longevity Annuity Contract (QLAC)
The QLAC, a deferred annuity funded from a qualified plan or IRA, has become increasingly popular in recent years as a new vehicle for retirement income. As of 2015, new Treasury regulations allow a QLAC to be purchased inside of a retirement account, which enables individuals to defer a portion of their RMD from age 70.5 to as late as age 85. Since a QLAC can only be funded up to $125,000, it limits how much of the RMD can be deferred.
Electing to purchase a QLAC is effectively counting on the fact that you will live longer; otherwise, the benefits of a QLAC may not be realized. For example, a retiree who opts to delay RMDs until age 85 may pass away before annuity payments from the QLAC even begin. In addition to the longevity risk, QLACs have a unique payment structure that front-loads many of the associated costs, meaning it can take up to 10 years just to break even and recover the principal inside the annuity. For many QLAC buyers, they would need to live well past their average life expectancy to make the investment worth it, so the risk of lost growth on the QLAC principal can be disproportionate to the benefit of deferring their RMD.
In summary, as you anticipate your annual RMD, it’s important to be aware of the various strategies that may help you reduce or defer its tax implications. Your wealth advisor can help you determine which strategy – if any – may be appropriate for you.
Originally published on 5/23/17. Updated on 2/12/19.