Photo by Diana Parkhouse on Unsplash
IRAs and retirement plans allow tax-deductible contributions as well tax-deferred growth of your investment. If you have invested into an IRA or 401k consistently and wisely over your working lifetime, you may have accumulated $1 million or more in your account.
That’s quite a chunk of change, but it comes with some strings attached. One of the biggest is the requirement that a certain amount of money must be distributed from these plans once you turn age 72. These Required Minimum Distributions (RMDs for short) are based on the previous year-end account balance and an actuarial table used by the IRS.
What’s more, RMDs must be taken whether you need the money or not and continue for the rest of your life.
Most people need the money from their IRA to meet living expenses. So, the question of what to do with your RMD is pretty obvious: pay the bills. However, if you don’t need some or all of your RMD amount, you may want to consider using your IRA RMD in one of these unique ways.
Support your favorite charity. Qualified Charitable Distributions or QCDs can be used to meet some or all of your RMD. QCDs must be made directly to a legitimate 501(c)3 charitable organization and are limited to $100,000.
The benefit of a QCD is that the RMD amount does not raise your Adjusted Gross Income (AGI). AGI is important because this the number that is used to determine taxation of Social Security benefits, Medicare premiums, and other tax considerations.
Another benefit is that most people file their taxes using the Standard Deduction amount. If your itemized deductions, including charitable donations, are less than the Standard Deduction amount you effectively receive no tax deduction for your charitable contributions. QCDs allow you to give money directly to charity without it affecting your taxable income.
In plain English -- if you are over age 70, own an IRA and are already giving money to charity, it may be more tax efficient to do so using the QCD rather than a direct donation from your checking account.
Gift money to family members. Years ago, I had a client who had more than enough income from Social Security and pensions to meet her needs. She decided to help her grandkids pay a portion of their college expenses.
Not only did her generous gift help them avoid student loans, it relieved her adult children from the burden of trying to pay for college while also juggling all their other financial responsibilities. The benefit to my client was that she was able to help her family during her lifetime rather than leaving her entire estate to them after she was gone.
The IRS allows individuals to gift up to $15,000 per year to any other individual without incurring gift taxes or creating other estate planning problems. If you are married, you can gift up to $30,000 per year to anyone for any reason. 529 college savings plans allow for even larger gifts.
Of course, your kids are doing great and don’t really need any financial help. Or do they? According to the Education Data Initiative, “Student borrowers aged 30-44 owe 49% of the national student loan debt balance or $823 Billion”. If you break it down by age, 28% of people in their 30’s, 13% of those in their 40’s and 12.5% of adults in their 50’s have their own student loans to pay.
Even if your kids are fine, their kids are looking at college expenses that are several times higher than what their parents had to pay when they went to college. After accounting for scholarships and other financial aid, the total cost of attendance at most of the schools your grandkids are attending will range from about $20,000 to well over $40,000 a year. Few families have the savings and discretionary income to meet these expenses for all of their kids.
Use life insurance to multiply your IRA for the benefit of others. Most people with large RMD amounts that they don’t need reinvest the after-tax proceeds into mutual funds or other long-term investments. With luck, these investments will grow over time, but there is no guarantee of that.
An alternative would be to use the after-tax RMD proceeds to pay for life insurance premiums on a policy that provides a guaranteed, tax-free benefit to the beneficiary(ies). The death benefit is generally a multiple of what was paid in premiums.
Before you immediately say “no” to the idea of using your IRA RMD to buy life insurance consider this: life insurance death benefits provide a guaranteed cash payment to your beneficiaries that is income and (if done right) estate tax free. “Guaranteed” and “tax free” being the key words.
A person with a $1 million IRA would have an RMD of over $35,000 each year. Assuming you are in good health, the after-tax amount of that RMD could purchase up an insurance policy with a $1 million death benefit. This benefit gets paid out to your beneficiaries and is completely exempt from state and federal income tax. This way, instead of inheriting an IRA that will be heavily taxed, your beneficiaries receive a tax-free life insurance death benefit and the remaining IRA balance when you die.
Of course, that may be more money than they need, but isn’t the whole point of investing an IRA to have it grow over time? If your RMD can be used to multiply the after-tax value of your IRA wouldn’t that make sense?
Taking the life insurance idea a step further, an IRA owner could list her favorite charity as the beneficiary of her IRA and her children as beneficiaries of the life insurance policy. This way the beneficiaries receive a tax-free inheritance and the IRA passes completely tax-free to the favored charity.
Here’s the math: Let’s assume a $1 million IRA passes to family beneficiaries and has an eventual tax bill due of $250,000 (for example), leaving a net inheritance to the beneficiaries of $750k. If the RMD proceeds are used to purchase $1 million of life insurance, the family could receive up to $1 million tax-free from the life insurance PLUS whatever is left in the IRA.
Alternatively, if the IRA owner lists a charity as beneficiary on the IRA, and the family as beneficiary on the life insurance, the family receives $1 million tax-free from the insurance and the charity receives also $1 million (or whatever the balance at the death of the IRA owner) tax-free, from the IRA.
The only real obstacle with this strategy is the insurability of the IRA owner. Even people in their 70’s and older can qualify to buy life insurance, but they need to be in reasonably good health to be insurable. Obviously, that won’t be the case for everyone.
Roth IRA Conversions – sort of. You can always convert IRAs to Roth IRAs, but doing so does not meet your RMD for the year. However, once the RMD has occurred you are free to use the after-tax proceeds in any way you like. This could include paying the tax on future Roth IRA conversion amounts.
If your IRA balance is such that you will never use all the money in your lifetime and you are confident that the IRA will eventually pass to your family beneficiaries, converting IRA assets to Roth IRAs will reduce your future IRA RMDs since your IRA balance will be smaller. It will also create Roth IRA assets that will eventually pass on to others free of income tax. In this strategy, you essentially use your net RMD proceeds to prepay the tax on IRA assets that will eventually go to your beneficiaries by converting part of your IRA to Roth IRA during your lifetime.
Splurge on once-in-a-lifetime experiences. This is, perhaps, my favorite idea.
If the last two years have taught us anything it is that life is short and unpredictable. None of us knows how much time we have left on Earth. We know even less about the future of the people around us.
Since you can’t take your IRA with you when you die, why not use your RMD to fund a once-in-a-lifetime experience like a special vacation with your family or a special gift for yourself?
Here are a couple ideas…
Commission a unique piece of original art. When I turned 50 my wife commissioned a painting of my two daughters who were 8 and 10 at the time. Normally we wouldn’t spend a lot of money on this type of thing. Like most situations that involve me spending money, I wanted to wait a while before making a final decision.
When we met the artist, Linda Nelson, she said, “your girls will never be this age again”. Even in the best of circumstances time moves on, and she was right, the girls would never be like this again. I was sold.
The painting now hangs in our living room above our fireplace and is my most cherished possession.
Take your family on a cruise. A client of mine retired a few years ago. Like most clients his IRA has grown considerably and his Required Minimum Distributions have become sizable. He and his wife don’t need the income. Their kids are young adults about to launch lives of their own.
Earlier this year the four of them did an UnCruise adventure with a travel company by the same name. If you’ve ever watched the movie, Where’d You Go Bernadette, you have an idea of what an UnCruise is like – small groups with flexible itineraries that travel to exotic destinations like Alaska or the Sea of Cortez – hopefully with a little less drama.
My client was reluctant to spend the money. When I saw him recently he beamed. It was the best trip he and his family had ever taken. They kayaked the fjords of Southeast Alaska, blazed their own hiking trails, and spied wildlife doing what it does best – just. being. wild. Most importantly, they shared experiences they will never forget and may never have the opportunity to share again.
When it comes to making good use of your IRA RMD, I would say that was money well spent. Or you could just buy another mutual fund.
To discuss any of the topics in this blog or to learn more about how we can help you Cross The Bridge To A Confident Retirement, please contact me through my web site mikebranch.net, call me directly at 651-379-3935 or email me at mpbranch@focusfinancial.com.