It is currently happening to some and eventually, this will likely happen to all of us. I am referring to Required Minimum Distributions (RMD). The RMD is your required minimum distribution amount which the Internal Revenue Services requires you to withdraw each year from your IRA, SEP-IRA, Simple IRA or retirement plan account when you reach age 70 ½.
Even though there is a calculation -see below- that will help you to determine how much you must withdraw from your retirement account, your withdrawal can be more than the required minimum distributions, as mandated by the Internal Revenue Service.
Once withdrawn, the RMD will be included in your taxable income, which depending on the amount of income that you are receiving in retirement, could kick you into a higher tax bracket. Ouch! This feel even more painful if you consider that many people who are required to take annual required minimum distributions would rather just leave the funds in their retirement account because they don’t need the extra income.
When and How To Calculate The Required Minimum Distribution
The first thing that you must know is that according to IRS.gov, “The required minimum distribution for any year is the account balance as of the end of the immediately preceding calendar year divided by a distribution period from the IRS’s ‘Uniform Lifetime Table.’ A separate table is used if the sole beneficiary is the owner’s spouse who is ten or more years younger than the owner.”
If you own multiple IRA accounts, you can withdraw the RMD from any one of your IRA accounts, based on the total value of your IRA(s).
What is the Beginning Date for Your Required Minimum Distribution?
- April 1st of the year following the calendar year of when you reach age 70 ½, for IRAs, including SIMPLE IRAs and SEP IRAs.
- Usually April 1st following the later of the calendar year that you become age 70 ½ or finally retire, for 401(K)s, Profit-sharing, 402(b), or similar defined contribution plans.
Example of What Happens Once You Turn 70 ½?
- Having retired, your 70th birthday was June 30, 2013. You became 70 ½ on December 30, 2013. Therefore, your RMDs will be due by April 1, 2014 from the previous year.
- Having retired and your 70th birthday was August 1, 2014. You became 70 ½ on February 1, 2015. Although you will not have to take RMD for 2014, you will have to withdraw RMD by April 1, 2016, based on the amount actually withdrawn in 2014.
Here is the calculation if your spouse is the sole beneficiary of your IRA and he or she is more than 10 years younger than you:
IRA balance on December 31st of the previous year? Answer: _________________
Your age on your birthday this year? Answer: _____________
Your spouse’s age on his or her birthday this year? Answer: _____________
Life expectancy from “IRS Life Expectancy Table II” at the intersection of your and your spouse’s ages?
Divide line 1 by the number entered on line 4. This is your required minimum distribution from this year from the IRA. Answer: $____________
Repeat steps 1 through 5 for each of your IRAs
BEWARE!!!…of the Consequences for Failing to Withdraw Your Required Mandatory Distributions
Whatever you do, do not make the mistake of NOT withdrawing your required minimum distributions by the due date. If you do, then the IRS will gladly hit you with a 50% excise tax on the amount that you were supposed to withdraw! Double ouch! By the way, if you are the non-spouse beneficiary of someone else’s IRA and they die, then you are required to take RMDs by December 31st in the year after the year in which the original IRA account holder died. For example, if the original IRA account holder died on January 1, 2016, then the non-spouse beneficiary must begin taking RMDs by December 31st of 2017.
Now for the Good Stuff! How You Can Convert Your Required Minimum Distributions Into Tax Free Income.
When someone takes their required minimum distributions in many cases they do not have an immediate need for those funds. Therefore, one solution to beat the IRS as its own game is by using the unwanted required minimum distributions to purchase life insurance with cash value, such as an Index Universal Life (IUL) policy. IUL is a cash value based life insurance policy where a portion of the insurance premium (in this case whatever amount of your unwanted RMDs you decide to allocate to an IUL) payments are deposited into a fixed account (in some instances this account is an interest bearing account) or an account that is ‘pegged’ to a particular index, such as the Dow Jones Industrial Average (“DJIA”), Standard & Poor’s 500 (S&P 500), and/or a bond index.
As the cash value account grows tax deferred, you will have the opportunity to take withdrawals on a tax free basis. Be advised that cash value policies such as an IUL have “surrender charges” that will reduce the value of your cash value account by a percentage that can be as high as 10%.
Usually, the Surrender Charge is higher in the early years of owning a cash value policy and it gradually declines year over year by 1% to 2% until the policy becomes “surrender free.”
The cash value has the opportunity to compound with positive performance of the underlying index. When withdrawals are taken they are considered “policy loans.” In other words, the insured may “borrow” funds from his/her policy without having to pay taxes on the withdrawal. Now, before you get all excited and decide to sock away a small fortune in a IUL policy, you should first speak with a license insurance agent because you need to be careful to understand the impact of over funding a life insurance policy for the sole benefit of building up the cash value in anticipation of taking tax free withdrawals.
This is known as a “Modified Endowment Contract (MEC). A MEC is what occurs to a life insurance policy that has been funded with more money than allowed by the IRS. When a policy has been funded to the extent of becoming a MEC, it is subject to the same taxation as an annuity. The IRS does not consider MECs as an insurance policy.
Your life insurance agent should have the appropriate software to run insurance illustrations that will help him/her structure the policy for you so that it does not become a Modified Endowment Contract.
Use Required Minimum Distributions to Increase the Value of Your Estate
A final benefit of converting your required minimum distributions into a tax free income by purchasing an Index Universal Life insurance policy is that the face amount of the policy can be received by your beneficiary on a tax free basis. In addition, suppose you need long term care, but don’t want to purchase a separate long term care policy. There are life insurance policies available that are a sort of “hybrid policy” where up to 2% (depending on the policy) of the policies face amount may be liquidated and paid monthly to offset some of the costs associated with long term care.
If you were to use a portion of the policy to pay for long term care expenses, then the face amount of the policy will decline proportionately, although the cash value in the policy can still grow based on the performance of the underlying index.
The next time you receive a call from your financial advisor reminding you that it is time to withdraw your required minimum distributions, at least you can smile knowing that you now have a strategy to one up the Tax Man!
- Financial and Retirement Planning
- Portfolio Management and Investment Allocation (401K, IRA, Brokerage)
- Estate Planning
- Retirement Income Planning
- Insurance and Annuities