Why You Should Take RMDs For 2020
Retirement Daily Guest Contributor
By Andrew Serzan, CLTC, and David Buckwald, CFP
Required minimum distributions (RMDs) aren’t required for 2020. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, passed in March to help deal with the pandemic, suspended this year’s RMDs from IRAs, most company plans, and inherited retirement accounts. This can help many people avoid paying tax on retirement account withdrawals they don’t need.
That said, it may pay to go against the grain this year and take RMDs (or perhaps even more) from tax-deferred accounts, and pay the resulting tax sooner than necessary. Indeed, even people who don’t face RMDs might tap their retirement funds in 2020. After paying the tax, many options exist, and the best choice may be loading up on life insurance.
If skipping 2020 RMDs will defer tax, why take them? Because today’s relatively low tax rates present an ideal opportunity to reposition capital by moving money from assets likely to be taxed at higher rates in the future, into assets that never will taxed at all within a permanent life insurance policy.
By using life insurance astutely, investors can leverage their wealth and enjoy some protection from creditors as well. If the insurance is structured properly, with valuable riders, the policy also can help address the surging costs of long-term care.
Failing to move wealth from a tax-deferred plan is likely to lead to a future tax trap. Tax rates have to rise in order to address the Medicare crisis, the Social Security crisis, and the ever-mounting federal debt. By 2026, forecasts predict that 92% of all revenue flowing into the federal government will go to Social Security, Medicare, Medicaid, and servicing our national debt. When other federal programs will need money then, the easiest targets will be the billions of dollars held in IRAs, 401(k)s, and other tax-deferred retirement accounts.
Out with 70 ½, In with 72 for RMDs
Formerly, many holders of tax-deferred retirement accounts were required to take RMDs once they reached age 70-1/2. IRS tables spelled out the amount that must be withdrawn. Any shortfall was subject to a 50% penalty!
The SECURE Act, passed in late 2019, increased the starting age for RMDs to 72, effective in 2020, for those not already subject to RMDs. Otherwise, the RMD rules remained in place.
Suppose Al Brown, age 76, had $500,000 in his IRA at the end of 2019. Al can afford to support his lifestyle without taking any money from his IRA. Even so, IRS tables generally require a 76-year old to take at least 4.55% from a retirement account, so Al would have had to take at least $22,750 from his IRA this year (4.55% of $500,000). Al could take more, but not less. And the $22,750 would have been added to his other taxable income for the year, taxed at ordinary rates.
Under the CARES Act, Al needn’t take anything from his IRA in 2020. He can let all the money stay in the account, untaxed, cutting his 2020 tax bill by thousands of dollars.
No Way Out
If seniors such as Al can trim their taxes by thousands of dollars by not taking RMDs this year (and still maintain their retirement lifestyle), why should they take their RMDs and accelerate tax payments? Let’s look at the long-term impact of skipping RMDs.
Skipping RMDs means Al’s IRA won’t be depleted by that $22,750 mentioned above. Instead, his IRA will remain intact, and may continue to grow. Meanwhile, the IRS table assumes larger RMDs, year after year, as a percentage of an individual’s IRA. For instance, Al will have to take an RMD of 5.35% at age 80, and 6.75% at age 85.
By skipping RMDs in 2020, Al will be taking out a larger portion of a larger IRA in future years, when RMDs resume. In addition, tax rates are scheduled to go up sharply in 2026, under the Tax Cuts and Jobs Act of 2017. Considering the expenses incurred by the federal government to help the economy recover from COVID-19, there’s a chance that future tax rates will be even higher than currently expected. Thus, Al might be paying much more in tax on his RMDs as he goes through retirement.
Going one step further, assume Al takes only RMDs throughout his lifetime and passes a sizable IRA to his widow, Carol. Under current law, Carol can follow her own RMD schedule, but she’ll eventually owe at a higher tax rate as a single filer, barring remarriage.
Going yet another step further, assume Carol dies five years later, having taken only RMDs from that IRA, which she leaves to the couple’s children, Dan and Eva. Again, that money will come out, sooner or later (with a hard cap after 10 years), and tax will be owed. It’s possible that Dan or Eva (or both) will still be in their peak earning years when they take distributions from the inherited IRA, so the income from those withdrawals could move the beneficiaries into the highest future tax brackets then in effect.
The bottom line is that tax will always be owed on withdrawals from traditional IRAs, 401(k)s, and other tax-deferred retirement accounts. The more money in these accounts, the more taxable income will be reported in the future—perhaps at unexpectedly high tax rates.
Although future tax rates can’t be known, it’s certain that today’s income tax rates are relatively modest, by recent standards. Suppose Al and Carol Brown expect their taxable income to be around $120,000 this year. Al could take $22,750 from his IRA—the amount of his scheduled RMD—and owe about $5,000 in tax, as the couple will stay in the 22% bracket.
Assume Al sets aside $5,000 for the tax bill. What could he do with the $17,750 balance? He might put that money into a regular taxable account. If he chooses stocks or stock funds and equities move up after this year’s volatility, Al could take long-term profits at a tax rate of only 15% or 20%, under current law, when a need for cash arises.
Or, Al could simply hold onto the stocks in this taxable account, owing tax only on the amount of dividends generated each year. At his death he could pass the equities to the couple’s children who would get a basis step-up and owe no tax on prior appreciation.
Alternatively, Al might convert $22,750 of his traditional IRA to a Roth IRA. He’d owe the same $5,000 in tax, as mentioned above. Eventually, all Roth IRA distributions could be tax-free. (As Al already has passed age 59-1/2, he would have to hold the account for five years before all Roth distributions avoid tax.)
Al might repeat such conversions for several years, following the RMD schedule. He would keep within the 22% tax bracket, moving money from tax-deferred to possibly tax-free territory as long as current tax rates remain in place. (They’re now scheduled to expire in 2026.)
If Al needs money, he can tap the Roth IRA, tax-free. If Al needs little or no money from the Roth IRA, he can pass it to a beneficiary or beneficiaries. Roth IRA owners never have RMDs; withdrawals by beneficiaries also can avoid being included as taxable income.
Leaning Towards Life Insurance
An even better strategy could be for Al to take the $22,750 RMD amount from his traditional IRA this year, set aside $5,000 for income tax, and put the balance into life insurance. I would suggest buying permanent life insurance, with a cash value investment account, rather than term life insurance with no cash value.
Depending on 76-year-old Al’s health, for an annual premium over $17,000 he might be able to acquire a permanent life policy with a death benefit of $300,000 or more. Any investment returns within the policy’s cash value will avoid income tax. This process—take IRA withdrawals, set aside money for tax, use the balance for life insurance premiums—can be repeated every year.
If Al needs cash, he can take withdrawals from or loans backed by the policy’s cash value without owing income tax. At his death, the $300,000 insurance payout would pass to the policy’s beneficiary or beneficiaries free of income tax, even if the insurance proceeds far exceed the amount of premiums Al has paid.
In this scenario, Al’s loved ones could receive a substantial death benefit, tax-free, as well as whatever is left in the tax-deferred traditional IRA at his death. (If Al is concerned about estate tax, the policy could be held in an irrevocable life insurance trust, out of his estate.
Assuming that Al chooses this life insurance-based strategy, he will have many types of life insurance to choose among. Some of these—variable life, variable universal life, indexed life—offer some exposure to possible stock market gains.
The plans mentioned above apply to retirees who are in the RMD stage of life, with RMD amounts used as examples. However, the ideas presented here have a broader application.
For instance, traditional IRA withdrawals don’t have to be limited to the amounts from the IRS table. If Al is married, filing a joint tax return, with 2020 taxable income around $120,000, he could take more than the $22,750 RMD amount from his IRA this year. The 22% tax rate for married couples goes up to $171,050 of taxable income in 2020, so Al might be able to take as much as $50,000 from his IRA and still owe tax at only 22%.
In addition, taxpayers who have not yet reached age 72 can begin to use this approach to draw down tax-deferred retirement accounts, with their built-in tax liability, at a moderate tax rate. They can then put the after-tax amount into cash value life insurance. The younger and healthier you are when you start the process, the more life insurance you’ll be able to purchase and the greater the potential tax-free payout.
Going forward, tax-free money is bound to become more valuable. Given the federal fiscal reality, benefits must go down or taxes must go up. Politically, slashing benefits is not a viable solution, so tax rates are bound to rise.
As recently as the 1980s, individual income tax rates were as high as 70%. Considering the current top rate of 37% and some politicians’ statements about today’s financial situation, we are likely to be heading towards such high tax rates in the coming years. Tax hikes also could come in the form of higher gift and estate taxes, capital gains being subject to ordinary income tax rates, and possibly the repeal of stepped-up basis at death, which would impose lookback taxes on unrealized gains.
The turbo tax train is coming, bearing down on everyone with substantial income or assets, and money in retirement accounts money is a sitting duck on this train’s rails. Tax-deferred accounts are wonderful vehicles for accumulating wealth but they are absolutely disastrous when the time comes for distributing and transferring money. Successful individuals and families must proactively manage their tax brackets if they wish to retire with more security and peace of mind in this extremely volatile world, and eventually leave a valuable legacy.
Considering today’s circumstances, the bottom line is that higher tax rates are looming in the future, considering scheduled tax hikes as well as the strain that stimulus efforts have placed on the federal budget. Already, the budget deficit has increased by 20% in the last two months; we likely will have more bailouts coming. COVID-19 has thrown gasoline on the already burning fire.
Tax rates have nowhere to go but up and qualified, tax-deferred money is an easy target. The larger your retirement account, the greater your exposure to higher tax rates on distributions. Given this environment, why not be proactive with your planning and tax-proof your retirement funds now?
No matter what your age or stage of life, it’s important to trim tax-deferred retirement accounts as long as withdrawals in relatively low tax brackets are possible. Leveraging the after-tax withdrawals with tax-free life insurance can be a winning parlay: You can reposition assets with a potentially huge tax liability into never-taxed assets for the future!
About the authors: Andrew “Drew” Serzan and Dave Buckwald
Andrew “Drew” Serzan is the head of private client and executive life insurance planning and a founding partner and principal of OneTeam Financial, a holistic consulting firm based in New Jersey. Drew specializes in the areas of retirement, wealth transfer and preservation, and insurance and investment planning and works diligently to help clients understand the decisions and opportunities presented by their unique situations, working alongside them and their other advisors to help implement their strategic plan. Questions about your specific situation? Contact Drew – firstname.lastname@example.org
Dave Buckwald is the CEO and Founder of OneTeam Financial and has been providing financial advice and guidance to clients for more than 30 years. He works with individuals, families and business owners to help them achieve their financial goals so they can spend more time doing what makes them happiest. His mission is to help clients preserve the wealth that’s taken a lifetime to build with specialties, including life insurance, estate planning and wealth transfer strategies. Connect with Dave – email@example.com