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Retirement Perspectives

Mandatory withdrawals in the form of annual required distributions present a considerable tax challenge, but early planning strategies may minimize the impact. 

Some clients may not need or want required minimum distributions (RMDs) from their employer plan and/or IRAs. For example, instead of taking the additional income, they may prefer to leave the assets to their heirs. In any case, forgoing the distribution is not an option, as the failure to satisfy an RMD will result in a federal tax penalty of 50% on the amount of the distribution that was supposed to be taken, but wasn’t. Further, taking the forced distribution will incur additional income taxes every year. So what’s an individual to do?

Let’s unpack this question.  RMDs have a mandatory start called a required beginning date (RBD). The initial or first RMD must be taken no later than April 1 of the year following the year an IRA owner (including SEP and SIMPLE) turns 70½.  Notably, government rules permit the first RMD to be deferred to April 1 of the following year. 

Although it’s impossible to totally avoid RMDs, early planning can help to reduce RMDs, thereby minimizing the tax hit.  Here are several examples: 

1. “Still Working” Exception
The “still working” exception permits individuals who continue to work for the plan sponsor to potentially defer RMDs until the later of 70½ or the separation from service. Assuming the plan has such a provision, the exception applies only to those workers who own 5% or less of the business.  In other words, a plan sponsor is not required to offer the still working exception.

Tip:  Prior to rolling over 401(k) assets into an IRA, be sure to discuss the still working exception. For those individuals working past 70½ who do not own less than 5% of the business, the plan may allow deferral of their RMD.

Tip: If your plan allows “roll-ins,” you can roll over your pretax IRA dollars (including SEP and SIMPLE) to your 401(k) plan, thus delaying RMDs on these additional funds, too. However, if you have an RMD for the year from your IRA, you must take it prior to rolling the remaining funds.

A 403(b) also can utilize the still working exception, thus delaying RMDs until April following the later of the year that an individual turns 70½ or separates from service

(Click here for more information on the still working exception.)

2. Consider a Qualified Longevity Annuity Contract (QLAC)
A QLAC is a deferred annuity purchased with a portion of your IRA or 401(k). It is the sole exception to the IRA RBD of April 1 of the year following the attainment of age 70½ Here, the funds invested in a QLAC do not have required distributions until age 85. The amount of the annuity is not counted when determining your RMD calculation until your annuity start date, which is the month after you reach age 85. In other words, a retirement investor excludes the value of the QLAC from his or her account balance when calculating the RMD payment. A deferred-income annuity is one way to ensure you'll have additional income later in life, when you may need it most. 

Participants in a 401(k) and IRA owners may use 25% of their account balance or $130,000 to purchase a QLAC

Tip: The 25% limit is applied to each employer plan separately, but in aggregate to IRAs.

3. Qualified Charitable Distribution (QCD)
If you are planning on donating money to a charity, consider a QCD.

For IRA owners who are 70½, a QCD would allow the tax-free transfer of up to $100,000 annually to a qualifying charity. The QCD also would satisfy your RMD, but without being subject to taxation.

Tip: QCDs are not available from 401(k) plans; only IRAs are.

4. Roth
One of the most powerful features of a Roth IRA is it is not subject to a lifetime RMD. If reducing a RMD is a priority, and/or leaving a tax-free legacy is important, consider converting pretax retirement dollars to a Roth IRA, thus avoiding minimum distributions.

While the conversion itself is subject to taxation, a conversion can take place at any time and at any age.  In addition, consider partial Roth conversions annually, thus preventing being “bumped” into a higher marginal tax bracket.

Tip: While Roth IRAs are not subject to lifetime RMDs upon reaching 70½, Roth 401(k)s are.  Consider rolling Roth 401(k) funds into a Roth IRA, thus avoiding RMDs.

Tip: Non-spouse beneficiaries are subject to RMDs from an inherited Roth IRA.  However, these distributions are not always tax-free.

Joint Life Table
The annual minimum distribution requirement is a percentage of the retirement account that must be distributed each year. RMDs in general are determined by dividing the previous year’s fair market value (on December 31) by the applicable life expectancy factor (based on the age of the account owner) located in IRS’s Uniform Life Table.  This table is used by IRA owners during their lifetime (e.g., lifetime RMDs). It’s based on the joint life expectancy of the account owner and 10-year younger beneficiary.

An exception is available for a spouse who is the sole beneficiary of the retirement account and is more than 10 years younger that the account owner. Here, the account owner refers to the IRS’s Joint Life Expectancy Table to determine his or her RMD (using the actual joint life expectancy of the account owner and his/her spouse).  In other words, in situations when there is a sole spouse beneficiary who is more than 10 years younger, it always will be advantageous to use the Joint Life Table to calculate RMDs, thus resulting in smaller RMD!

Tip: A spouse beneficiary to be treated as a sole beneficiary generally must be the sole beneficiary for the entire calendar year.

403(b) and Age 75
Participants in a 403(b) can defer RMDs on pre-1987 funds until age 75.

DIY (Do It Yourself)
After turning 59½, you have full and complete access to your IRAs without being subject to the 10% federal penalty tax. In essence, you have more than 10 years (age 59½ to 70½) to create and execute a plan for income from your IRAs. For example, you may be retired and are in a lower tax bracket, thus having an ideal opportunity to take voluntary taxable distributions from your IRA. These “early” distributions would offer an additional benefit by reducing your RMDs later on.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

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