You've saved for years to get to retirement, and you’ve seen the power of tax-deferred growth, but those taxes can’t be deferred forever. Once you reach age 70½, unless you meet limited exceptions, you must start taking required minimum distributions (RMDs)—and you will pay the tax bill every time you do.
Required minimum distributions (RMDs)
The U.S. tax code allows you to save for retirement in tax-deferred savings accounts, but at some point you have to begin withdrawing those savings and reporting the withdrawals as income. Generally, the drop-dead date by when the withdrawals must begin, or “the required beginning date” (RBD), is April 1 of the calendar year after the calendar year in which the account owner turns 70½. The RBD applies to all IRAs (other than Roth IRAs), including SEP IRAs and SIMPLE IRAs, and other qualified plans such as 401(k), 403(b) and profit-sharing plans.
Likewise, when your beneficiaries inherit your retirement assets, they will also have to pay income tax on the amounts they receive. Typically, they will have to start withdrawing assets in the year following your death.
If you don’t need the distributions to support your lifestyle, you may be wondering what to do with the proceeds. You may even be thinking about the impact these accounts will have on your children–especially if they earn more than you or live and work in a high income tax state.
Here are a few strategies that might reduce your tax bill now and the future bill for your heirs.
Qualified charitable distribution (QCD)
Generally, IRA distributions, including RMDs, can only be made directly to the account owner. An exception exists for owners that are at least age 70½, allowing them to direct distributions directly to a qualified public charity. There are certain requirements in order to do this:
- The monies must come from an IRA; (it cannot be an employer plan such as a 401(k) or 403(b)).
- The monies must go directly to a charitable organization. Donor-advised funds and private foundations generally don’t qualify. The payment to charity can be a single contribution or multiple contributions and can include as many charities as desired up to a maximum of $100,000 per year.
The gift does not qualify for a charitable income tax deduction, but the amount distributed is not considered ordinary income and is not taxable. At the owner’s option, it can count toward your RMD for the year. This means that you can reduce your annual income, which is likely to reduce your income taxes. A QCD may be particularly beneficial for those that will not itemize their deductions.
A Roth conversion refers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA. Deciding whether to convert to a Roth IRA centers on issues like your tax rate now versus later, the tax bill you'll have to pay to convert (and where those funds come from), and your estate planning objectives, including your heirs’ income tax rates.
The difference between a Roth IRA and a Traditional IRA is that as long as you meet certain requirements, all withdrawals are tax-free.
Roth conversions not only eliminate RMDs for you but create an income tax free legacy for your heirs. Though your heirs will have to take annual RMDs, these distributions will not be subject to federal income tax as long as the account has been open for at least 5 years.
Lifetime income annuity payments
An annuity can provide you with income for life, and it may reduce the administrative burden of tracking how much you need to withdraw each year. Any amount you convert to an annuity payment satisfies your RMD and then the amount no longer figures into that calculation after you convert it. An annuity can provide a stream of lifetime income so you don’t need to worry about outliving your money.
You may already have annuity assets available in your retirement plan or IRA. Check with your employer or your custodian to see if you do.
Other RMD uses
If you don’t want the large tax bill associated with a Roth conversion, you can redeploy those RMDs in other tax-deferred or income tax-free assets for your heirs.
These could include:
- Roth IRA for heirs
- 529 plans
- Life insurance
Open a Roth IRA for a grandchild
Contributing to someone’s Roth IRA can give him or her a huge head start. If your grandchild has earned income from a job, he or she may contribute to a Roth IRA. The contributions may not exceed the amount of money earned for the year, up to a maximum of $5,500 in 2019.
The contributions you make now could grow enormously. Just a $2,000 contribution for a 16- year-old could grow to more than $60,000 by age 67 if the investments earn 7% per year.
If your grandchild is a minor (generally under age 18), there are special rules that apply, so you should be sure you understand them before opening or contributing.
College savings accounts (including 529 plans)
A Section 529 plan is an education savings plan sponsored by a state and operated by a state or educational or financial institution, and is designed to help families set aside funds for education costs. 529 plans offer beneficial income tax breaks. Not only will the monies in a 529 plan grow tax deferred, but distributions used for qualified educational expenses will be tax free. This includes up to $10,000 each year for elementary and high school tuition, or post-secondary tuition, books, and room and board.
If there is no current need for an RMD, you could consider purchasing a life insurance policy rather than reinvesting the withdrawal in a taxable account. In many cases, you would be allowed to withdraw the cash value of that policy if you wanted or needed it during your lifetime. Also, the death benefit proceeds from the life insurance policy would pass to your beneficiaries income tax free.
Now that you’ve made it to retirement, but don’t need those savings you should think about ways to save yourself and your heirs the income taxes on them. Talk to your planning professionals for help.