Pre-tax retirement accounts like IRAs and 401(k) plans provide an opportunity to receive an upfront tax deduction, and tax-deferred growth while the assets remain in the retirement account. For those saving towards retirement, this provides additional tax-deferred compounding growth that can bridge the gap towards retirement itself. Once in retirement, most individuals will start to take distributions, and the IRS will finally get their share of this retirement account.
To ensure this happens, the Internal Revenue Code (IRC) requires that retirement account owners begin liquidating their accounts upon attaining 70 ½. For most, this isn’t a big deal as those who actually need the income to fund their retirement lifestyle, will likely be taking distributions already. However, for those who don’t need their retirement accounts for income, the Required Minimum Distribution (RMD) obligation ensures that at least some of the assets are distributed and taxed every year.
The mandatory withdrawals of the RMD obligation presents a substantial tax challenge to those who don’t need to use their retirement assets yet, or at all. These distributions not only trigger taxes on the RMD amount itself, but may push the retiree into a higher tax bracket when combined with all of the other income sources as well.
Thankfully, though, the reality is that there are a number of strategies that can help manage and minimize RMDs to those who’ve already reached the RMD phase, and those still accumulating towards it.
Unfortunately, it’s impossible to completely avoid RMDs, because even if the account isn’t liquidated while alive, the beneficiaries are saddled with RMD obligations after the death of the original account owner. However, there are strategies that can manage and minimize RMDs and reduce the size of their tax bite!
Managing and Minimizing Current RMDs
For those who’ve already reached their Required Beginning Date - April 1st, of the year, after the year you turn 70 ½, when the first RMD is due, your options are limited. However, a few options to reduce the tax consequences exist, either as part of the IRC, or by managing around it.
The Still-Working Exception
An exception under IRC Section 401(a)(9)(C)(i)(ii) allows someone who is still working and not yet retired in the first place, allows any RMD from that employer’s retirement plan to be delayed until the employee actually retires. Notably, this exception applies only to that specific employer’s retirement plan accounts, not any other retirement accounts. For example, “old” 401(k) plans, or any IRAs are still subject to RMDs upon reaching age 70 ½.
Unfortunately, the “still-working” exception doesn’t work for business owners or self-employed individuals who own more than 5% of the employer stock or profits interest in a partnership or LLC. Rather, this exception can benefit “rank-and-file” employees, business owners (greater than 5% of the business) cannot.
A very interesting planning opportunity presents itself if the employer plan allows employees to roll in outside retirement accounts (not all do). There would be no RMD obligation for the accounts combined into the employer’s retirement plan!
Limitations to this strategy exists, of course. Under IRC Section 402(c)(2), only pre-tax dollars can be rolled into a 401(k), not after-tax dollars. Any after-tax contributions previously made to an IRA must remain behind in the IRA. Ironically, this may be helpful anyway, as a nontaxable Roth conversion as a backdoor Roth contribution, could be made. Since Roth IRAs don’t have RMD obligations, you can delay distributions indefinitely and never pay any taxes on them!
Delaying RMDs with a Qualified Longevity Annuity Contract (QLAC)
The potential role of longevity annuities as a retirement income strategy, has been increasingly focused on by academic research recently. Much like a traditional single premium immediate annuity (SPIA), longevity annuities, convert a lump sum of money into an illiquid, guaranteed stream of payments for life, or a period certain timeframe. The difference is, an immediate annuity begins payments immediately, while a longevity annuity don’t begin until later, sometimes much later. For example, a 65 year old couple could invest $100,000 into a SPIA, and begin receiving payments immediately of about $500/month ($6,000/year). A longevity annuity might delay the first payment until age 85, but provide payments of more than $2,500/month ($30,000/year).
This is due to a combination of the time value of money (20 years before payments begin), and the impact of mortality credits (payments are increased with the dollars of those who don’t live until payments begin). Ironically, this makes longevity annuities a very effective hedge against outliving one’s retirement dollars. If the retiree lives a long time he/she receives a very high payout rate (20 years later), and if the retiree doesn’t live a long time, then he/she didn’t outlive their retirement dollars, either.
Previously, there was a potential issue with longevity annuities in retirement accounts. If payments don’t start until age 85, it could run afoul of the RMD rules. To resolve this issue, in 2014 the Treasury issued proposed Regulations that would permit a limited portion of retirement accounts to be invested into a QLAC without violating RMD rules. Specifically, a maximum of 25% of a retiree’s retirement account balances (up to $130,000) can be invested into a longevity annuity and as long as the payments begin no later than age 85, you’ve satisfied the RMD rules for this portion of your retirement assets. This does not relieve the other 75% of the retirement assets from their RMD obligation.
By purchasing a QLAC inside of a retirement account can effectively delay the onset of RMDs altogether, to as late as age 85, for 25% of the account. The tradeoff, is that a QLAC typically makes no payments until much later, and a death in the interim may cause all principal to be lost, or a return-of-premium guarantee may return principal only, and no growth.
RMD deferral alone, is not a compelling strategy to buy a QLAC. With the life expectancy of a 65 year old around age 85, the odds are that the retiree will lose out on 20 years of potential growth just to delay RMDs. If you’re not optimistic about your own life expectancy, it would likely be better to keep the money invested, pay the taxes on the RMDs, than to delay RMDs and lose all potential of growth.
Satisfy an RMD with Qualified Charitable Distributions (QCDs)
IRC Section 408(d)(8) allows IRA owners to make a QCD from an IRA directly to charity, and avoid any tax liability associated with the withdrawal. Although, the donation is not eligible for a charitable deduction, it’s a perfect pre-tax wash (up to $100,000/yr) because the distribution from the IRA is not considered income in the first place.
One very important caveat of using a QCD to satisfy an RMD obligation, is that an RMD is presumed to be satisfied by the first distribution from the IRA for the year. Also, a RMD is not permitted to be rolled over back into another IRA. Once a RMD occurs, it is irrevocably distributed and (taxable).
The most straightforward way to accomplish this is to donate it to charity as a QCD and to do so as the first distribution of the year, to ensure that it actually counts toward the year’s RMD.
For those looking to make more substantial gifts, it is often more tax-efficient to donate highly appreciated investments (for example, stocks, mutual funds, or ETFs with embedded gains), and use QCD to offset the income tax consequences of taking a separate RMD. The reason is that while a QCD is a perfect pre-tax deduction that avoids the tax consequences of an RMD, donating investments with embedded capital gains obtains a charitable deduction of offset the tax consequences of the RMD and also permanently avoids the capital gains taxes on the investment itself!
Using a Special Exception with a Much-Younger Spouse
Since 2002, all retirement account owners must use the “Uniform Life Table” to calculate the annual RMD amount. The Uniform Life Table is the joint life expectancy of the retirement account owner, and a hypothetical beneficiary who is 10 years younger.
While the Uniform Life Table is required to be used regardless of the actual age of the retirement, (i.e., even if the beneficiary is actually more than 10 years younger than the retirement account owner), a special exception exists under Treasury Regulation 1.401(a)(9), permitting RMDs to be calculated based on the actual joint life expectancy of the retirement account owner and his/her spouse. If the spouse is more than 10 years younger, a smaller RMD, due to the longer joint life expectancy, would be the result.
As with all special exceptions, there is a limitation. The Table II of Appendix B of Publication 590 only applies if the much-younger spouse is the sole beneficiary of the retirement account, and must remain so for the entire year.
In situations where an IRA has multiple beneficiaries that include a much-younger spouse, it would advisable to split the IRA, and name the spouse as sole beneficiary of his/her share. This ensures the more favorable calculation for the spousal-beneficiary account, while the other accounts use the Uniform Life Table.
Contribute RMDs Back into a Younger Spouse’s IRA or 401(k) Plan
One way for married couples who don’t need their RMDs, but can’t find a way to avoid or delay it, is to simply re-contribute the RMD back into the younger spouse’s IRA or employer sponsored plan. While the IRC does not permit someone older than 70 ½, to contribute to an IRA, it may be possible for a spouse younger than 70 ½, to contribute to their IRA instead. You’re allowed to use the dollars just received from the RMD too. Or, where the contribution limits are higher, you can contribute to an employer sponsored retirement plan, like a 401(k) instead.
The biggest caveat to this strategy is that the younger spouse must be eligible to make a contribution in the first place. This means the spouse must have earned income to contribute to the IRA and/or be earning enough salary to contribute to a 401(k) plan.
Contributing to a Younger Spouse’s Retirement Account First
The optimal strategy, when it comes to RMD planning for couples already in or nearing the RMD phase, is to take distributions from the older spouse’s account first and allow the younger spouse’s retirement account to grow as long as possible.
An extension of this strategy, is to maximize contributions to the younger spouse’s retirement accounts first, while you’re still saving and accumulating. By design, those contributions will be further away from the RMD phase and have longer to accumulate and grow.
It’s important to consider and discuss the couple’s comfort level with disproportionate contributions to each individual’s account. Disproportionate saving into one spouse’s account versus evenly splitting between both may be a good strategy for RMD purposes, but in the event of a divorce, it can impact the division of assets.
In conclusion, while RMD obligations can’t be avoided altogether, there are many ways to look forward and plan for RMDs, while positioning strategies to delay or minimize the size of the RMD and to extend the period of tax-deferral.
Any opinions are those of James Hyre and not necessarily those of Raymond James. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete.
Expressions of opinion are as of this date and are subject to change without notice.
Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted.
Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.