Most people with significant assets in IRAs and 401(k)s let Congress and the IRS determine their spending and distribution strategies. That’s a big mistake that can cost them and their families quite a bit of money.
Most people don’t begin taking money out of their qualified retirement accounts until the required minimum distribution rules say they have to, according to a J.P. Morgan Asset Management study produced in 2021 that used data from both the Employee Benefit Research Institute and accounts held at JPMorgan Chase of middle- and upper-middle class households with $300,000 or more in their retirement accounts.
I view the RMD rules are a tax trap for many middle- and upper-middle class households. The longer distributions from traditional IRAs and 401(k)s are delayed, the higher the lifetime income taxes are likely to be for the owners and heirs.
Congress set the RMD rules for its benefit, not yours. It’s not always a good idea to defer taxes for as long as possible.
It’s important in the retirement years to shift from the savings mindset to the distribution and spending mindset. Create a thoughtful spending and distribution strategy.
Here’s an important finding from that J.P. Morgan Asset Management study. While most of the people didn’t begin distributions until required and took only the RMD amount, those who took distributions earlier tended to have more wealth than the median. I suspect that’s because they were more likely to have professional advisors and followed their advice.
Because of the way RMDs are computed and especially because of the rules heirs are subject to, it can be very expensive to leave money in traditional qualified accounts too long.
The problem is especially acute for people who have sufficient income and other assets to pay most of their retirement expenses. They view the traditional retirement accounts as emergency savings or legacies for their heirs. The result is they and their heirs pay significantly more income taxes and Stealth Taxes (such as the Medicare premium surtax and income taxes on Social Security benefits) than they need to.
To reduce those lifetime taxes and have more family after-tax wealth, consider repositioning your traditional IRAs and 401(k)s. There are at least six strategies to consider. The strategies are the most profitable when you expect income tax rates will be higher in the future, but also in other situations. You might find that one strategy or a combination of the strategies is best for you.
Reduce your IRA early. Years ago I ran the numbers and concluded some people should take money out of their IRAs before RMDs kick in and before they need the money to pay expenses. They should pay the income taxes and invest the after-tax amount in a taxable account.
Traditional IRA distributions are taxed as ordinary income. If your IRA is invested to earn long-term capital gains or qualified dividends, you’re converting tax-advantaged income into ordinary income. Over the long term, it can be better to have the money in a taxable account than continuing to compound in the IRA eventually to be taxed as ordinary income.
Your heirs also are likely to be better off inheriting the taxable account. Traditional IRA distributions to a beneficiary are taxed just as they would have been to you. The beneficiary really inherits only the after-tax amount.
Another advantage of a taxable account: When most non-IRA assets are inherited, the heirs increase the tax basis to current fair market value. They can sell the assets and owe no capital gains taxes. All the appreciation during your lifetime escapes taxation, giving the heirs the benefit of the full value of the assets.
Convert to a Roth IRA. Probably the most-used strategy today is to convert all or part of a traditional IRA to a Roth IRA.
You pay a tax to convert the IRA by including the converted amount in gross income. But a conversion eliminates future RMDs for the owner and, after a five-year waiting period, distributions of income and gains are tax free.
Distributions to beneficiaries also are tax free, but most beneficiaries will have to distribute the entire Roth IRA within 10 years after inheriting it.
You can convert any amount you want, and there’s no limit on the number of conversions you can do. Some people convert just enough each year to avoid jumping into the next higher tax bracket.
Turn the IRA into permanent life insurance. Repositioning the IRA as permanent life insurance can have several advantages.
The life insurance payout received by the beneficiaries is income-tax free. The amount your loved ones inherit with life insurance is fixed by contract and doesn’t fluctuate with the markets the way an IRA balance can. With some types of life insurance, the benefit might increase over time.
The life insurance benefit also is likely to be more than the current balance of the traditional IRA and almost certainly will be more than the after-tax value of the IRA. Details will vary with your age, health, and the type of permanent life insurance policy purchased.
You might have lifetime tax-free access to part of the policy’s value through loans from the insurer using the cash value account as collateral. The terms vary from policy to policy.
You can take one large distribution from your IRA and use the after-tax amount to buy the policy with a single premium. Or you can take regular IRA distributions and pay annual premiums with the after-tax amount.
The IRS-to-Dynasty-Trust Strategy. This is a variation of the life insurance strategy.
Instead of buying the policy, you set up a family dynasty trust and give the after-tax IRA distribution to the trust. The trust buys the policy and is the beneficiary, with the trust beneficiaries being your grandchildren, children or both.
After receiving the policy benefit, the trustee invests and distributes the money according to the terms you set in the trust agreement.
Having the benefit paid to the trust instead of the individual beneficiaries substantially reduces the risk the money will be poorly invested or spent rapidly or frivolously.
The charitable remainder trust. There are several ways to reposition the IRA as a charitable remainder trust, because CRTs are very flexible. You can use after-tax IRA distributions to fund a CRT that pays income to you and your spouse for life. Or you can name the CRT as the IRA beneficiary and have it pay income to other loved ones for life or a period of years.
After the income period ends, the assets remaining in the trust are given to the charity or charities you name when creating the trust.
The charitable gift annuity. A similar but simpler strategy is to reposition the traditional IRA as a charitable gift annuity. IRA distributions are used to buy a CGA that pays regular annual income instead of being transferred to a CRT.
A CGA will make lower income payments than a commercial annuity. The difference is a gift you’re making to the charity.