If you want more of your retirement savings to go to you and less of it to go to the IRS, you have to start paying attention.
Those required minimum distributions from your tax-deferred account are costlier than you think, especially if you don't take the right precautions.
Generally, you have to take required minimum distributions (RMDs) from most of your tax-deferred accounts (401(k), IRA, SEP, etc.) at age 70.5 whether you need them or not. As the advisors at T. Rowe Price point out, this creates a huge tax liability for affluent investors. According to Judith Ward, certified financial planner at T. Rowe Price, conversion could have huge repercussions for hypothetical married investor with an annual household income of $190,000 in the 28% tax bracket if that 54-year-old investor has $500,000 saved for retirement in a traditional IRA and $130,000 in a taxable account. If she continues to contribute $6,500 annually to the traditional IRA until age 65, things could get problematic.
If she keeps her money in a traditional IRA, she would have to take nearly $2.36 million in RMDs. However, even if the RMDs from the traditional IRA were reinvested in the taxable account, and the taxable account grew at a tax-adjusted rate of 4.32% per year as the IRA grew 6% annually, she would have to pay $659,600 in taxes on those RMDs.
"If you don't need the income, RMDs cause two problems: they erode the value of your retirement accounts and increase your taxable income," says Ken Nuss, CEO of AnnuityAdvantage, an online annuity marketplace.
One way for that hypothetical client to reduce that RMD bite a bit is to buy a qualified longevity annuity contract (QLAC), which is a deferred income annuity designed to meet specific Internal Revenue Service requirements that qualify it. By putting money in a QLAC, an investor excludes that cash from assets on which future RMDs are calculated.
QLACs have an accumulation or deferral phase -- where interest earnings are held and reinvested by the insurance company -- and a payout phase. You pay a premium and then choose when to start receiving your stream of lifetime income, though you have to do so by age 85 at the latest. The QLAC pushes back required distributions for up to 14 and a half years in some cases. For example, at age 75, $125,000 in a QLAC avoids $5,459 in RMDs you'd otherwise have to accept. At age 80, you'd be exempt from $6,684 in RMDs.
"The biggest advantage is that you'll create a larger stream of income you can't outlive," Nuss says. "The earlier you buy the QLAC, the longer you'll get to build up principal and the bigger payout you'll ultimately get."
However, there are some strings attached. The IRS notes that a QLAC is limited to 25% of the total of all your IRAs or $125,000, whichever is less. That $125,000 limit will be adjusted for inflation, but for some high-income investors, it may not be enough. However, if it is, that QLAC can be paid out to an individual or jointly, with the payouts ending only after the second spouse dies. In that case, the $125,000/25% limit is per person, which gives them $250,000 in required minimum distributions to avoid.
T. Rowe Price's Ward notes, however, that a Roth IRA conversion might be another solution worth pursuing. Her hypothetical client is on the hook for $2.36 million in RMDs in a traditional IRA and $659,600 in taxes on those RMDs even if she reinvests. However, if she began converting some of her money in the IRA to a Roth IRA at age 55, she's only have to take $622,000 in RMDs and pay $342,200 in taxes on it. If she lives to age 95, the $4,416,400 her accounts would have been worth in a traditional IRA will be worth $5,321,500 after being converted to a Roth IRA.
She'd have to pay taxes on the money going into a Roth IRA up front, but all the growth in that Roth IRA would come tax-free. She could also make withdrawals at her own pace without any tax liability.
So why not just start with a Roth IRA? Unfortunately, high-income investors are typically shut out of them. In order to contribute the maximum to a Roth IRA 2017, you must have an adjusted gross income of less than $117,000 for single filers and less than $184,000 or less for married couples, filing jointly (less than $132,000 and less than $194,000 or less, respectively, for partial contributions). However, you can convert assets from a traditional IRA to a Roth IRA at any income level.
"The longer you can keep your money in them, the better," says Anthony D. Criscuolo, a senior financial planner with Palisades Hudson Financial Group. "However, it could be wise to use assets in your Roth IRA for large emergency expenses, like major home repairs or medical bills."
That said, keeping your money in a tax-deferred IRA any longer than necessary can do real damage to your savings. The required minimum distributions are generally treated as taxable income, so they potentially can push investors into a higher tax bracket. They also might increase Medicare premiums take a bigger tax bite out of Social Security benefits. Those benefits are taxed based on your other income, which is generally the sum of your adjusted gross income, nontaxable interest, and half of your Social Security benefits.
"As your income rises, the proportion of your benefit that is taxable does, too," Criscuolo says. "If you take your Social Security benefit relatively early, allow for the ripple effect that taxation of your benefits could have on your overall tax rate."
Unlike tax-deferred accounts, however, Roth IRAs are not subject to RMDs. Meanwhile, any distribution taken after you turn 59.5 isn't subject to further taxation as long as the account has been held for at least five years
"If you withdraw a lot of money from a tax-deferred account, it might push you into a higher tax bracket, Criscuolo says. "But pulling a large amount from a Roth IRA will not impact your overall tax rate."
There are some exceptions to that kind of planning. If you have a low-income year, Criscuolo says you may want to pull some money from tax-deferred account to benefit from that year's low tax bracket. If you have a high-income year and investments in a taxable account have a lot of appreciation, he suggests instead withdrawing from a Roth IRA. If you own securities that have lost ground in a taxable account, selling some could be a good move in a high-income year to help offset your other income.
How do you know if a Roth IRA conversion is right for you? Well, if you expect to be in a higher tax bracket when you retire, paying taxes now at your lower current rate. Even if you think your tax bracket will remain the same or decline (and tax-free withdrawals will help lower it), there are still some advantages to conversion. Even if she doesn't start converting traditional IRAs to Roth IRAs until age 65, that same woman in the examples above would save about $400,000 in RMDs, $60,000 in taxes and $170,000 in total account value by the time she turned 90.
"The longer you have until retirement and the longer you live in retirement, the more time you have for a Roth IRA's potential growth to make up for the taxes you originally paid on the conversion amount," Ward says.