An Important Factor to Retirement Income Planning
by Brandon Buckingham, JD, LLMMr. Buckingham is Vice President, National Director, for the Advanced Planning Group for Prudential Annuities. Visit prudential.com.
November 7, 2016 — The oldest Baby Boomers, those born in the first half of 1946, turned age 70 ½ this year. This means the Required Minimum Distribution (RMD) rules will start applying to one of the largest demographics of Americans with millions more to follow in the coming years.
The impact of these rules on such a large group requires a careful understanding of the rules as well as consideration of various strategies to help manage these distributions.
The tax-deferral benefits of IRAs and 401(k) plans were created to incentivize people to save for retirement. However, retirees eventually will have to pay the tax bill on these accounts. The RMD rules were designed to ensure just that. People who fail to take a required distribution will have to pay a 50% penalty tax. This is one of the largest penalties in the Internal Revenue Code.
Managing RMDs is an important factor in any retirement income plan. RMDs can push a retiree into a higher tax bracket, which in turn could increase the tax on other sources of income as well as Social Security benefits. It could also affect the premium a retiree pays for part B Medicare coverage as those are determined by the retiree’s reported income. Failure to comply with and properly manage RMDs could negatively impact an otherwise solid retirement income strategy.
- Owners of IRAs must begin distributions by April 1st of the year following the year the account owner reaches age 70½. This is true whether or not the IRA owner is still working.
- However, participants in employer sponsored retirement plans, such as 401(k) plans, can wait until the later of age 70 ½ or when they stop working. One exception. Participants who own 5% or more of the business must take their first required distribution at age 70 ½ regardless of whether they are still working or not.
- Other than the first required distribution which can be delayed to the April 1st deadline, all subsequent required distributions must be made by December 31st of the year.
- The amount of the required distribution is determined by dividing the prior year end account balance year by the account owner’s life expectancy.
- RMDs will increase each year on a percentage basis.
- IRA owners or plan participants who fail to make the required distribution for a given year must correct the error and pay a 50% penalty tax.
Clients approaching 70 ½ will want to be sure that their retirement portfolio is tax diversified. Having taxable, tax deferred and tax free accounts will allow retirees to better control their tax bracket, the timing of their taxes and their tax liability.
Strategically converting IRAs to Roth IRAs will reduce future RMDs and increase tax free income in retirement. An advisor can help clients determine if and how much should be converted each year. A common practice would be to convert an amount that would fill up your current tax bracket.
Taking Distributions prior to Age 70 ½
Another approach could include taking IRA withdrawals sometime after age 59 ½ but prior to age 70 ½. This would reduce the amount of money subject to RMDs in the future and thus reduce RMDs themselves. The increased cash flow caused by taking withdrawals early may allow the IRA owner to defer Social Security and maximize those benefits for a larger payout in the future.
Furthermore, smaller RMDs could increase the tax efficiency of a retiree’s income by reducing the amount of Social Security benefits subject to taxation. For married couples filing jointly with provisional income less than $32,000, Social Security benefits are not taxable and with income between $32,000 and $44,000, only 50% of benefits will be subject to taxation. At a maximum only 85 cents of every Social Security dollar will be taxable instead of 100 cents of each taxable IRA dollar.
RMDs must be taken from each 401(k) plan whereas IRAs can be aggregated for RMD calculation purposes with the RMD only taken from one or less than all IRAs. This could permit the IRA owner to satisfy the RMDs from more liquid accounts and keep other IRAs fully invested for continued growth potential.
Qualified Longevity Annuity Contracts (QLACs). QLACs provide another way to reduce RMDs. A QLAC is a deferred income annuity, providing longevity insurance, which typically start distributions at age 85. Taxpayers can allocate the lesser of $125,000 or 25% of their retirement assets to a QLAC. Money allocated to a QLAC is not included in the determination of the taxpayer’s account balance when calculating RMD for the year.
For clients who do not need the income from the required distribution, they could take advantage of the qualified Charitable Distribution. Clients over age 70½, can distribute up to $100,000 each year directly from an IRA to qualified charities. The distribution can be used to satisfy the taxpayer’s RMD and the distribution will not be added to the taxpayer’s taxable income.
The IRS RMD Tables will require IRA and 401(k) owners take a larger percentage of their account each year. The annual increase in the RMD withdrawal rate can create a risk there will be little left for the surviving spouse. To help mitigate this risk, some annuities will offer certain protective riders, for an additional fee, that can address the market, longevity and timing risks inherent in all IRAs, as well as provide guaranteed income over the lives of both spouses.
For instance, a Guaranteed Minimum Withdrawal Benefit (GMWB) with a “spousal” rider could guarantee a withdrawal rate over the lives of both spouses. The withdrawal rate is guaranteed regardless of market performance and regardless of how long the IRA owner and his or her spouse live. Furthermore, some GMWBs “Spousal” riders are “RMD friendly” meaning that at any time the RMD exceeds the rider’s allowable withdrawal rate, the annuity will permit such withdrawal without adversely affecting or reducing the guarantee. In other words, the IRA owner and his or her spouse will be assured to receive the greater of the guaranteed withdrawal amount or the RMD each and every year for the rest of their lives.
With millions of Baby Boomers turning age 70 ½ everyday for the next 18 years, a successful retirement income plan needs to include a careful consideration of the RMD rules and incorporate strategies to manage these distributions. But don’t wait until age 70 ½.