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Articles, wit and wisdom about retirement planning, tax management and living a long life.


How to Minimize RMD

Many people are surprised to learn that they have to take Required Minimum Distributions (“RMDs”) when they reach the age of 72.  The RMD rule applies to IRS sanctioned retirement savings plans (“Plan” or “Plans”).  These Plans have names like an IRA, a 401(k), 403(b), 457(b) and other acronyms.  Contributions to these traditional retirement savings Plans are made with “pre-tax” dollars – an individual taxpayer’s Plan contributions are reductions in that person’s gross taxable income.  Also, an employer’s Plan contributions are not taxable to the employee.  Even better, assets in each Plan can grow free of income tax.  Of course, the IRS eventually wants tax revenue. So, all distributions from these traditional retirement Plans are taxable to the Plan beneficiary/recipient. 

Some retirees can maintain their lifestyles without withdrawals from their IRA or similar Plan.  Given the wealth-creating power of compounding returns without tax, these retirees often want to allow their Plan assets to grow tax-free as long as possible - without taxed distributions.  Unfortunately, the tax rules specify an annual Required Minimum Distribution (“RMD”) for all “Traditional” Plans.  The RMD rule applies once a person reaches age 72 and each year after that.   An RMD distribution shortfall is subject to a 50% penalty as well as the regular income tax.

Careful tax planning can assure that there are annual withdrawals from a Plan at least equal to the RMD.  But can a taxpayer reduce or eliminate the RMD exposure to maximize the benefit of tax-free compounding?  The answer is yes, but it takes planning and the right facts.  Below are some approaches.

ROTH 401(K) PLAN

Plans with a “Roth” in their title have tax treatments that differ from Traditional Plans.  Contributions are treated as taxable income or not deductible, but distributions are tax exempt.  Many if not most employers (offering 401(k) plans) give the employee the option of having a Roth or a Traditional 401(k) Plan.  As a result, today there are many billions of dollars in assets held in Roth 401(k) plans.   The RMD rules are the same for both Traditional and Roth 401(k) Plans. 

Here, there is a simple solution to the RMD problem.  A Roth IRA has no RMD requirement ( the Traditional IRA is subject to RMD).  A Roth 401(k) plan can be rolled over into a Roth IRA without creating taxable income.  Absent some extraneous factor; all Roth plans should be transferred to a Roth IRA before the RMD rules apply.  Of course, the rollover will have to occur when an employee has the authority to transfer the account, usually after leaving employment with the plan sponsor.

TRADITIONAL PLAN ROLLOVER

Can a person roll over to a Roth IRA if he or she holds assets in a Traditional Plan (e.g., 401(k) or IRA)?  The short answer is “yes,” but there are two hurdles to a rollover from Traditional to Roth:

  • The rollover amount is taxed as ordinary income in the rollover year.
  • No distributions from the Roth IRA can occur for five years after the rollover.

The rollover amount can be less than the total Traditional Plan asset balance.  Any distributions needed for the five years after the rollover should be held back in the Traditional Plan. After the fifth year, the Roth IRA is free to make some or no distributions to its beneficiary.

An individual’s tax situation dictates whether or not this rollover strategy makes sense.  For example, assume a person will be in a high tax rate at the rollover date and expects a low or no tax in a future distribution year.  A rollover in this example would be inappropriate.   The ideal time to do a rollover is in a year when an individual’s taxable income is unusually low.  Such a person might be between jobs, early retirement before benefits are paid, report deductible passive losses from real estate investments, etc.   Also, it is possible to plan multiple rollovers to multiple Roth IRAs over the years.  The rule is to do the rollover in a tax year when rates are low, or there are sufficient losses. Even more important – run the numbers and do a sensitivity analysis on both assumed tax rates and investment rates of return.

Here is an important point.  If the rollover into a Roth IRA occurs when the RMD rules apply, an RMD distribution will still be required in the rollover year.

There is no age restriction on a Plan roll as far as income taxes.  Still, the Plan’s language must allow the event.   For more on how to manage lifetime income using a Roth IRA, see our blog article on the topic.  

PLAN TERMINATION

A simple way to avoid RMD is to terminate the Plan before the beneficiary reaches age 72.  Generally, a penalty is triggered by a termination or Plan distribution before age 59½.  After age 59½, the beneficiary of a Traditional Plan is free to withdraw any amount so long as it equals or is greater than the RMD for that year. Withdrawal of all Plan assets will terminate the Plan.  Please recall that Traditional Plan withdrawals are taxed as ordinary income.

Just like with a rollover to a Roth IRA, distributions should be planned to occur in the year(s) when the Plan beneficiary has low or no other taxable income. So doing, the tax cost of the distribution(s) will be minimized.    Once received, the funds can be reinvested by the Plan beneficiary in his capacity as an individual investor.  The tax-advantaged choices are many – non-dividend paying stocks, deferred annuities (variable or general account), real estate, oil & gas, etc. Tax deferral depends upon the nature of the assets selected for re-investment.

A QLAC

If a person owns a Traditional Plan, the IRS has created a new type of qualified tax annuity – the Qualified Longevity Annuity Contract (“QLAC”).  The IRS authorized this new class of annuity contract in 2014 to help taxpayers of more modest means to assure themselves that their Plans would never run out of money.  Under the IRS rules, a QLAC must have the following attributes: 

  • The annuity must be deferred and not be an immediate annuity;
  • Once payments begin, the annuity is for the remainder of the beneficiary’s life;
  • The annuity must start no later than the owner’s 85th birthday;
  • The policy must be a “general account” insurance product – not variable;
  • The owner and a spouse may be joint beneficiaries;  and
  • The maximum QLAC premium is the lesser of $130,000 or 25% of Plan assets.  (The $ 130,000-lifetime limitation was increased to $130,000 from $125,000 on January 1, 2018, and will rise from time to time after that.)  
  • There are two significant benefits of buying a QLAC: 
  • Taxable income does not arise from a Plan withdrawal if used to pay a qualified QLAC premium;
  • The Plan assets are reduced by the premium withdrawal for computing RMD.

 It is important to recognize that a QLAC is an annuity, a form of insurance policy – not an investment contract.  A QLAC guarantees a fixed income for the life of the policy owner (and spouse, if elected).  There is also an available election that provides that the sum of all payouts must be equal to the premium paid.  Assume a QLAC was purchased for $125,000 with the annuity to begin at age eighty-five.  If the QLAC owner dies at age eighty, then his estate will receive $125,000, a refund of the premium paid.  (Without the return of premium election, there would not be benefits payable to the beneficiary’s estate ).  As a result,  a conservative analysis assumes that the QLAC return is 0% but never negative. On the other hand, the RMDs are reduced because the Plan assets are reduced by the distribution to pay the QLAC premium.  As a result, the beneficiary has more pre-tax dollars at work.  

The benefit of a Plan without a QLAC withdrawal is that there are more Plan assets which can grow tax-free inside the Plan – but higher RMDs.  Of course, without a QLAC, all the Plan assets are subject to investment risk.

Increased Plan distributions have distinct tax disadvantages.  Funds moved outside the Plan are taxed 100% as ordinary income - thereby reducing available re-investment assets.  Further, the remainder assets typically generate taxable income, further reducing asset growth. 

Once again, there is no one best answer concerning the above tradeoffs.   For each person, the right answer depends on the assumed tax rates, when the QLAC annuity begins, and the expected rates of return inside the Plan - as well as the rate of return on the invested distributions.  The QLAC can be an “investment” when the return of premium election is made.  As part of a portfolio of invested assets, the QLAC could be categorized as low or no risk while the assets in the Plan might be at incrementally higher risk than without the QLAC.  Finally, for many investors, there is a very important ‘sleep at night’ factor of knowing that a well-rated insurance carrier guarantees a certain part of future retirement income. 

CHARITABLE CONTRIBUTIONS

Once the RMD age is reached, a Traditional IRA can make a qualified charitable contribution up to $100,000. (To take advantage of this option, other Traditional Plans need to transfer assets to the IRA.) That contribution is treated as an RMD distribution for purposes of the RMD test but is not treated as taxable income to the Plan beneficiary.   For all intents and purposes, the IRS is assuming that the distribution’s imputed income and charitable deduction offset and neither need be reported.

Of course, instead of having the IRA make the contribution, a beneficiary could take a $100,000 distribution and turn around and make a $100,000 charitable gift.  For high-income individuals, there are disadvantages to this alternative approach.  First, the individual’s Adjusted Gross Income (“AGI”) will be increased.  A variety of tax rates kick in at higher levels of AGI.  Also, some personal deductions are limited as AGI becomes higher.   For example, itemized deductions (i.e., contributions to charities) are reduced when AGI exceeds certain thresholds (e.g., $155,650 if married filing separately).  For most high-income taxpayers, the net effect will be more taxes to pay under this second approach than if the beneficiary had simply instructed the IRA to make the charitable contribution.

A beneficiary’s charitable intent is the starting point of this RMD minimization strategy.  Having the IRA fulfill that intent is just a better way. Note that the $100,000 is a maximum only.  For Plans with less than $2.5 million in assets, typically, the RMD amounts will be less than the $100,000.   While a Plan could limit its charitable transfer to RMD, the charitable gift by the IRA could be less or more than the RMD – just not more than $100,000 in a given year.

An interesting approach might be to use a QLAC to reduce the Plan assets and after that, dedicate the reduced RMD to charitable gifting.

ANNUITIES

Buying an annuity such as an Immediate or Deferred annuity inside a Traditional Plan may achieve planning objectives, but these purchases are not a means of reducing RMD.  (A QLAC is not a traditional annuity and should not be confused with the annuity contracts described below for this discussion.) 

An Immediate annuity (annuity payments begin within 12 months of the purchase date) distribution is often treated as a deemed RMD.  The annuity distribution is 100% taxable to the beneficiary.  The Immediate annuity is great for the person who seeks a risk-free return and lifetime income. 

A Deferred annuity (annuity payments begin after 12 months of the purchase date) has another issue.  Unlike an Immediate annuity, the Deferred annuity has a cash value designated by the annuity contract or imputed by the IRS.  As a result, RMD will be computed each year based on that cash value.  Sufficient liquid assets need to be held in the Plan but outside the Deferred Annuity to assure there are available distributions to cover the computed RMD.  Once the annuity begins its payments, the payouts are typically deemed equal to the RMD.  This approach offers little or no opportunity to defer RMD.

Traditional annuities are not vehicles to accumulate assets tax-free inside a Plan.  Any tax deferral inside the annuity becomes irrelevant when the asset is held inside a Traditional or a Roth Plan.  Avoiding RMD is a strategy to allow assets to grow tax-free typically for a future beneficiary.  Annuities are about providing secure lifetime cash flows to the Plan beneficiary.  

 SUMMARY

Avoiding or minimizing RMD is for future or current retirees who do not or will not need their savings inside a Traditional Plan. A Plan that buys an Immediate or Deferred Annuities will not help reduce the RMD and will likely reduce or eliminate residual assets at the end of the beneficiary’s life.

Good Planning tools include distributing Plan assets to buy a QLAC, moving some or all of the Plan assets into a Roth IRA, distributing Plan property at an opportune time and fulfilling charitable gifting via a traditional IRA. The QLAC has no tax toll charge on the transfer from a Plan, but it is limited in the percentage of assets that can be used to pay a QLAC premium.  Transfers from a Tradition Plan to a Roth IRA (or simply outside the Plan) are 100% taxed, but that tax can be managed by doing one or more transfers in low tax rate year(s).  Finally, making charitable gifts from an IRA reduces RMD and is tax efficient for high-income taxpayers.

There is not a perfect solution for all.  Instead, minimizing RMD requires thoughtful planning with a keen eye focused on the beneficiary’s objectives and not just tax minimization.

Want to learn more? Check out our videos page to see additional QLACguru videos.  See our calculators page to develop an anonymous RMD calculation and estimated QLAC quote. Answer specific questions by going to our Knowledgebase page.  Visit our blogs page for in-depth articles on a variety of topics including how QLACs help with sequence Sequence Risk, how QLACs are similar to and different from Social Securitybest practices in buying a QLAC as well as many other topics. Free Consultation.  If you would like us to develop a free RMD analysis and illustration of how a QLAC might work for you, please click here.



A Failsafe Roth Plan

A FAILSAFE ROTH PLAN

In decades past, most employer pension plans fell into the category of a Defined Benefit Plan (“DB plan”).  That is, when an employee retired as a beneficiary of a DB Plan, he or she received a monthly payment for his or her retirement life span.  The DB plan payment amount was determined by formulas driven by the employee’s length of service and compensation while working for the employer.  The employee benefit was independent of the pension plan’s financial performance or the plan’s investments. 

Today, the numbers of DB Plans have declined dramatically and have been replaced by Defined Contribution Plans (“DC Plans”).  Defined benefits are not part of a Defined Contribution Plan – the available distributions from a DC Plan are determined by the magnitude of contributions and the plan’s earnings.  Once a Defined Contribution Plan beneficiary retires, there are minimum withdrawal rules, but nothing that prevents a beneficiary from making withdrawals such that DC Plan assets are fully spent or depleted before that retiree dies.  The major shift from DB Plans to DC Plans in the USA coupled with lower average returns, poor savings rates, higher healthcare costs, and greater longevity has created a nation worried about running out of money during retirement.   

In a prior blog article, we described an approach that guarantees that an IRA Plan beneficiary will not outlive his or her savings.  That approach is the “Failsafe Strategy.”  To implement the strategy, a person with a traditional Individual Retirement Account (“IRA”) (or other qualified DC Plan) divides his IRA assets into two “buckets.”  The first bucket distributes a fixed annual amount from the IRA from the start of retirement to a future annuity start date (e.g., between ages 70 to 85). At the end of the first bucket’s tenure, there can be few or no assets in the IRA. The second bucket is a Qualified Longevity Annuity Contract (“QLAC”) that pays an annual benefit (e.g., starting at age 85) for life.  The tax rules allow a withdrawal from a traditional IRA Plan to be tax exempt if invested in a QLAC.  Accordingly, the QLAC premium amount was withdrawn from the IRA before or at age 70 and the QLAC lifetime annuity benefits were determined at the purchase date.  Click here to see a calculator we developed especially for developing this kind of plan.

ROTH PLANS – NEW KIDS ON THE BLOCK

Traditional DC Plans come in a variety flavors and scents – examples include an IRA, a 401(k), a 403(b), a 457(b), a SEP IRA, a Keogh, and a SIMPLE plan.  Each of these plans shares common attributes:

·         Each has its definition of who can contribute and the contribution limits of the plan;

·         The contribution is with pre-tax compensation or earnings;

·         Retirement distributions from the plan are 100% taxable income to the beneficiary.

In 1997, Roth IRAs became a new Defined Contribution Plan option.  Next, in 2001 Congress created Roth 401(k), Roth 457(b) and Roth 403(b) DC Plans. The Roth DC Plans were made permanent in 2006.  Since then, the plan’s popularity has grown.  For example, there were over $500 billion in Roth IRA assets in 2013.

 So, what is different about a Roth versus a traditional DC Plan?  

·         The contributions to the Roth plan are with after-tax compensation or earnings;

·         Retirement distributions from the plan are 100% tax-exempt to the beneficiary.

The income earned inside the Roth DC Plan is also tax exempt – just like a traditional Defined Contribution Plan.  Generally, the implementation rules are the same.  For example, both Roth and traditional 401(k) plans are subject to the same Required Minimum Distribution (“RMD”) rules after the plan beneficiary reaches age 70½.  There are important exceptions.  Here is one: a traditional IRA is subject to the IRS RMD requirements, but a Roth IRA is not.  This is an essential difference that enables us to create a Failsafe Roth strategy.

The 2014 QLAC regulations specifically exclude any distributions from a Roth Defined Contribution Plan.  Of course, any distribution from the Roth Plan is already tax exempt.  As a result, a distribution can be used by the beneficiary to buy any annuity.   The problem is that distributions from that annuity, purchased outside of the Roth, will no longer be fully tax exempt.  Instead, each distribution will include a return of the premium cost (which is not taxed) and the earnings that occurred inside the annuity (which is taxed).

The problem is solved by having a Roth IRA buy an annuity and be its beneficiary.  In other words, the Roth IRA will divide its assets into two buckets.  The first bucket will distribute cash to the beneficiary over a predetermined period – just like a traditional IRA.  The second bucket is used to buy a deferred annuity with a distribution start date (e.g., age 85) just like with a QLAC annuity.   Unlike a traditional IRA that distributes funds out of the plan to purchase a QLAC, The Roth IRA plan is the owner and beneficiary of the annuity.  Annuity benefits are paid to the Roth IRA, which in turn, can distribute the cash receipts to the Roth IRA beneficiary.  So doing, the Roth IRA distributions are fully tax exempt.  By using a Roth DC plan to purchase the annuity, a beneficiary is not constrained by the $125,000 cap ($130,000 starting in 2018) which applies to a QLAC purchase.

An individual may have a Roth 401(k) plan and not a Roth IRA – or have both.  To be sure, 401(k) plans have larger contribution limits.  As a result, an individual’s Roth 401(k) plan can accumulate more savings during his or her working years than a Roth IRA. It is important to recognize that employer 401(k) plans are not uniform.  Today, more than half employer-sponsored 401(k) plans allow an employee to elect either a Roth or a traditional plan.  

Many - if not most - plans require that when an employee resigns, he or she may (or is required to) “rollover” the plan assets into an IRA or another 401(k) plan.  Similarly, when an employee retires, there is a rollover requirement or option.  Also, employer-sponsored plans will be administered by a trustee (also, called a custodian) such as Principal Financial or Fidelity.    The investments available to the plan participant will be those approved by the employer from a list of investments often managed by the trustee’s related fund managers.  A dozen or fewer choices are typical.

When a rollover option or requirement happens, generally it makes sense to move the assets from the Roth 401(k) to a Roth IRA. (Note – rollovers done incorrectly can trigger tax and penalties.  IRS Publications 560, 575 and 590A are helpful reading.  Better yet, consult a tax expert before executing a rollover.)  Even though a transfer to another Roth 401(k) is also a tax-free transfer, remember that a Roth 401(k) plan is subject the RMD required distributions whereas a Roth IRA does not have an RMD requirement.   A non-IRA Roth DC plan could easily fail the RMD test if it holds both buckets – regular investment funds and an annuity.  Assuming there are same investment options, there is no advantage of a rollover to a Roth 401(k) versus a Roth IRA.

Here's another reason for moving to Roth IRA rather than to a Roth 401(k).  Before executing a rollover, the participant must choose a new trustee.  This is an important choice.  For example, Fidelity may offer a short list of annuities that underperform a long list of annuity choices at Principal.  The choice of a plan trustee is a choice of the kind of deferred annuity that is available.  It is important to note that Roth IRA trustees are available that allow “self-directed” investments by the beneficiary.   A self-directed Roth IRA has a truly independent trustee that is agnostic about the purchases selected by the participant. 

 Many of the insurance companies selling annuities will create a Roth IRA to receive the rollover proceeds earmarked to purchase that company’s annuity contract.   Once an annuity is targeted for purchase, it makes sense to ask the carrier if they offer the ability to create a Roth IRA to receive funds designated to buy their annuity.  Creating a new Roth IRA is a service offered for nominal or no cost. 

Please note that a Roth 401(k) rollover can be to more than one Roth IRA.   It is possible to have one Roth IRA to hold the assets to fund the first phase of retirement (i.e., the first bucket) and a second Roth IRA to hold the life annuity to fund the second phase of retirement (i.e., the second bucket).  Such a breakup might be motivated by selecting a plan sponsor with a good investment track record for the first bucket and using a self-directed plan or an insurance company trustee to acquire the second bucket’s deferred annuity.

SUMMARY

A Roth 401(k) (or a Roth IRA) can duplicate the same Failsafe strategy available to a traditional DC Plan that distributes funds to buy a QLAC annuity.  While there are a couple more steps, they are not complicated:

·         Determine the two phases of retirement funding;

·         Divide the Roth DC Plan assets into the two buckets of retirement assets;

·         Migrate  the  two buckets  of assets into one or more Roth IRAs;

·         Purchase a deferred life annuity in one Roth IRA;

·         Distribute bucket one assets during the first phase of retirement;

·         Distribute bucket two assets (annuity receipts) during the second phase of retirement.

Because the Roth IRA buys a life annuity, the participant collects income for however long he or she may live.  Accordingly, it is impossible to outlive one’s savings. 

Want to learn more? Check out our videos page to see additional QLACguru videos.  See our calculators page to develop an anonymous RMD calculation and estimated QLAC quote. Answer specific questions by going to our Knowledgebase page.  Visit our blogs page for in-depth articles on a variety of topics including how QLACs help with sequence Sequence Risk, how QLACs are similar to and different from Social Securitybest practices in buying a QLAC as well as many other topics. Free Consultation.  If you would like us to develop a free RMD analysis and illustration of how a QLAC might work for you, please click here.





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