Required Minimum Distributions, A Scary Term to Some Seniors – Learn How to Mitigate This Requirement

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When it comes to retirement planning and managing retirement savings, many seniors can be overwhelmed by all the laws, requirements, options, considerations, and other issues that abound.

Some of these things can be downright scary for individuals who have saved diligently over a long period toward achieving their retirement goals. They simply desire to enjoy their golden years in peace and without hassle.

Two particular items that tend to concern seniors, aside from death and taxes, are the Internal Revenue Service (IRS) mandated required minimum distributions or RMDs, and annuities.

Rather than being intimidated by RMDs and annuities, you need to understand both and gain some perspective on how one can be successfully used to address the other to your advantage as you move forward into your retirement years.

What is an RMD?

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RMDs are scary to many because they simply don’t know much about them and they involve the IRS, an agency that spooks anyone with a pulse.

So, let’s start by shedding light on the dreaded required minimum distribution rule imposed by the IRS.

Tax-Deferred Investing

You’ve been preparing for retirement for some time by making contributions into a qualified retirement account on your own, such as a Traditional IRA or an employer-sponsored account like a 401(k).

The dollars invested were contributed pre-tax, providing the dual benefit of reducing your taxable income in the year of contribution (so you paid less tax), as well as allowing your retirement account investments to grow and enjoy the benefit of compound interest on a tax-deferred basis.

Tax Man Cometh

Well, the IRS wants their pound of flesh at some point. The RMD is a mechanism allowing the agency to eventually capture taxes due by forcing individuals to take distributions from qualified retirement accounts starting at age 72.

Important to keep in mind that each passing year thereafter your life expectancy decreases, so your RMD requirement actually increase.

While there’s more to them, that’s the basics.

(Note: Learn more at the RMDs – Key Things to Know accompanying sidebar)

Annuities – Equally Scary

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Again, time to pull the curtain back and shine a light on that which might have you uncomfortable.

It’s a Contract

Simply stated, an annuity is a form of insurance contract offered by an insurance company. You buy the annuity today through what is referred to as a premium payment (lump sum or periodic payments over time), and in return receive a contract spelling out specific terms and conditions.

Annuities can be used to grow your money on a tax-deferred basis or to provide lifetime income – many people use them to do both.

Annuities have two phases, the first of which is accumulation, where you will pay for the product in one lump sum or through periodic payments over time.

The second phase is the payout period. Traditionally, if you needed income in retirement you would annuitize your annuity, which in reality meant turning over the value of your annuity to the issuer in return for a stream of income. This could be over a fixed prior or for the rest of your life.

Today the vast majority of annuities are never annuitized, according to the LIMRA LOMA Secure Retirement Institute.

With advancements in product offerings, such as a lifetime income rider (some have fees and others don’t), you now have the ability to receive a lifetime income stream without ever annuitizing your annuity.

They enable you to take payouts and still maintain the annuity (you retain your principal), allowing it to continue to grow and increase your retirement assets, as well as maintaining a potential death benefit.

Annuity Types and Characteristics

Generally speaking, annuities come in a couple flavors – immediate (fixed payments that start within the first 12 months of purchase) and deferred, which won’t begin to pay out until potentially much later.

Big but…depending on the deferred annuity and it’s contract language, during the deferral period, which can last up to years (again, depending on the annuity), you can typically take out up to 10% of your money without annuitizing the annuity. That’s an income stream during your retirement without annuitizing your contract.

If you happen to pass away in the deferral period, your annuity value (principal and interest) gets passed to your family.

There’s also a longevity annuity which is a fixed annuity designed not to start paying out for many years (up to age 85).

Additionally, there are two major categories for annuities, fixed index and variable.

fixed index annuity provides you benefit of obtaining market upside, but without the risk because your money isn’t placed directly in the market. The interest generated is tied to the positive movements of an external index, such as the S&P 500, allowing you to obtain growth in your annuity, which is important over the long term, but it is 100% guaranteed against market declines – you won’t lose money if the market goes down.

A variable annuity (VA) is a contract whose value fluctuates based on the underlying performance of what are called sub-accounts, which are much like mutual funds. You have direct market risk as your money is directly invested in the market. Oak Harvest never recommends variable annuities.

Qualified and Non-Qualified Annuities

One last consideration regarding annuities is whether they are qualified or not. Both qualified and non-qualified annuities grow tax-deferred, so you don’t pay taxes on returns until you start taking payments.

A qualified annuity is funded with pre-tax dollars from a qualified retirement account, such as certain IRA plans, 401(k)s and others.  Qualified annuities are subject to RMD.

A non-qualified annuity is purchased with after-tax funds, so there is no RMD requirement. Once payouts begin the payments are taxed as ordinary income.

The good news about annuities is the fact they can offer you and your financial advisor tremendous flexibility in terms of optimizing your portfolio when it comes to income and taxes.

RMD Strategies Utilizing Annuities

Okay, now we’ve demystified and removed the fangs from these two important retirement elements. Now it’s time to take a look at how you can utilize annuities to mitigate RMD requirements in a manner that can be advantageous to you.

Here are two strategies utilizing annuities that help reduce and even eliminate some of your RMD obligations.

Immediate Annuity Strategy

This is a strategy for reducing your RMD by investing a portion of your qualified retirement account(s), such as an IRA or 401(k), into an immediate annuity.

In purchasing an immediate annuity you receive the benefit of knowing you have an income stream (generally paid monthly) for life, a fixed period, or for both.

There can be serious downside to this approach and really should only be considered if you need income right away and don’t have other streams of income available. You definitely want to consult a retirement planner before engaging in this strategy.

This type of annuity is funded with a lump sum contribution that begins to pay out almost immediately (within first 12 months of purchase). There is no contribution limit, unlike your IRA or 401(k) account.

The immediate annuity purchased isn’t subject to the distribution rule, as the IRS considers the RMD requirement covered by the income stream provided by the annuity. As such, the RMD obligation is offset by the portion of the account invested in the immediate annuity.

An example would be purchasing a $50,000 immediate annuity in an IRA valued at $250,000. Your RMD requirement when you turn 72 would be based on $200,000 versus the full $250,000, given the immediate annuity portion of the account would be excluded from the RMD calculation.

You would still have to calculate your RMD obligation for the remaining $200,000, but you would have effectively reduced the overall RMD requirement.

Keep in mind that while you’ve reduced your over obligation as just demonstrated, you still receive income and pay income taxes on that amount distributed each year from the immediate annuity.

Delaying RMD Using a QLAC

A very unique RMD strategy utilizing a type of deferred fixed annuity involves purchasing a qualified longevity annuity contract or “QLAC”.  As implied in the name, this is a form of a qualified long-term annuity that provides guaranteed income for life, ensuring you don’t outlive your savings. They are typically purchased to provide payouts that will occur years later.

The QLAC is funded by an investment from one of your qualified retirement accounts, such as an IRA or 401(k). The contract is part of the qualified account, but it is exempt from RMD rules until an age specified in the contract. Unlike an IRA, it can remain exempt from RMD requirements until the year you reach age 85, at which point you must begin required distributions.

Key QLAC Considerations

  • The longer you wait to take a distribution (annuitizing the contract and beginning payouts), the larger your payouts will be
  • Regarding an investment into a QLAC, your savings are protected from market fluctuations, so that money remains stable and safe based on the claims-paying ability of the insurance company
  • This is a fixed annuity, so while you can grow your principal in the annuity (until annuitization and generally at a low fixed rated stated in the contract), you can’t use an Indexed Annuity, effectively giving up the opportunity to obtain potentially higher returns on your money
  • A QLAC does reduce the amount of RMD that must be taken in a qualified retirement account starting at age 72. This reduces your income each year (RMD payouts) and saves taxes. It also potentially keeps you from being bumped into a higher tax bracket, thus owing even more taxes. And remaining in a lower tax bracket can also result in lower Medicare premiums
  • If you want to guarantee an income stream that starts later in your retirement years a QLAC is an option
  • You can add a death benefit feature that guarantees your beneficiaries will receive 100 percent of your uncollected premiums.

Keep in mind that there is a cap on the amount that can be invested into a qualified QLAC. While the contributions can come from more than one qualified retirement account, the maximum amount of contribution from any one account can’t exceed 25 percent of that account’s total value. Additionally, the collective total amount that can be currently contributed to a QLAC is $145,000.

You will definitely want to work with your financial advisor before implementing this strategy as part of the overall financial plan governing your retirement portfolio, as there are myriad considerations.

Conclusion

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Keep in mind that the two annuity strategies listed above are but a couple of a number of approaches that can be implemented to advantageously address RMDs.

Overall, it’s important to remember that while RMDs can be intimidating – there are lots of issues and considerations to be weighed – they shouldn’t cause fear or trepidation.

The same holds true for annuities – there are many types offering myriad benefits and advantages…there is no need to fear them.

The good news is a qualified retirement advisor can make both less scary, providing guidance and a strategy best suited to your retirement needs.

Be sure to contact us today to ask questions about RMDs or annuities, and to discuss your overall retirement goals and how we might be of assistance in reaching them.

Sidebar: RMDs – Key Things to Know

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The amount of your RMD is based on your age, the size of your qualified retirement portfolio, and your life expectancy according to the IRS’ Uniform Lifetime Table.

RMDs are calculated on the value of your qualified individual retirement account (combined value if you have multiple IRAs) and separately for the qualified employer accounts, you might have, such as a 401(k).

An RMD is required to be taken from your IRAs (either a single distribution from one account or from multiple accounts) and separately the same applies to your qualified employer account(s).

Remember, you don’t have to take the first RMD until the year following the year when you turn 72, but you will have to take two in that year…in April for the previous year (when you turned 72) and again by 12/31 for your current year RMD.

The two distributions combined can potentially push you into a higher tax bracket, resulting in higher taxes that will have to be paid on your increased income for that year.

Also, the increase to your adjusted gross income could trigger other unpleasant consequences, such as higher taxes on your Social Security benefits, a surtax on your taxable investments, and a Medicare high-income surcharge.

Currently, the initial distribution requirement at age 72 is slightly under 4 percent of your overall portfolio value, with the percentage increasing each year thereafter.

Oh, by the way, keep in mind that if you fail to take your required distribution in whole or in part in any given year, you will be penalized 50 percent of the RMD not taken for that year, in addition to the taxes owed for the distribution taken.

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