Others know that RMD stands for required minimum distribution, but they don’t understand how the calculation and taxation work.
Once you turn age 70 ½, the IRS requires you withdraw a percentage of your money in qualified accounts (401(k), IRA, 403(b), etc.) by December 31 each year. Many people don’t realize this money is also counted with their other income and taxable at the current rate.
How to use your RMDs
For many, this might not be an issue, since they will withdraw at least the required minimum distribution amount for their income each year. But what about those who don’t need to depend on that money?
Some people have pensions and Social Security covering their living expenses. Others have real estate producing income, and they wish they didn’t have to take out RMDs and pay taxes on them each year.
Leaving tax-efficient IRA money
Many of those same people want to leave money behind for their families. But, what about the taxes? When leaving IRA/qualified funds to their heirs, the current tax rate could apply, which can push a person into a higher tax bracket.
There are different inheritance options, depending on if the beneficiary is a spouse or someone other than a spouse. Only spousal inheritance provides an opportunity to create a spousal transfer from either a traditional IRA or Roth IRA. The funds can be transferred to the spouse’s existing IRA, or a new one, with penalties applied to withdrawals made before the spouse reaches age 59 ½.1
All other options for spouses and non-spouses involve taking distributions no later than December 31 of the year of the account holder’s death (for account holders who are over age 70 ½) or no later than December 31 of the year the account holder would reach age 70 ½ (for account holders under 70 ½); transferring the assets to an inherited IRA, which involves a five-year distribution method; or a lump-sum distribution.2
One alternative to leaving an IRA to a beneficiary is utilizing a tax-advantaged life insurance plan. This strategy can be custom designed to fit your personal needs.
A permanent life insurance product’s cash value grows tax-deferred. You can access that cash value within IRS guidelines. We can help design a strategy for maximum death benefit or maximum cash value.
Maximum death benefit
If your focus is on leaving the most amount of money to your family, the maximum death benefit can be a great option. Depending on your specific financial situation, a level or increasing death benefit aligns with this strategy. In a level death benefit, the actual death benefit is outlined in the life insurance contract and remains the same during the entire life of the account holder. With an increasing death benefit, the account value increases over time, until the account holder passes.
Generally, the beneficiary will not have to pay taxes on the money received from the death benefit.3 That means your heirs likely won’t pay taxes on the legacy money upon your death. And, compared with an IRA beneficiary, life insurance inheritances are not a part of the account holder’s estate and, therefore, typically don’t go through probate.4
Maximum cash value
Others want to maintain liquidity, use, and control of their money. In that case, the maximum cash value plan could work best.
To do this, we follow the IRS guidelines to lower the death benefit, which reduces the cost of insurance, and accelerate cash-value potential. With this product, you’ll have access to your money on a tax-favored basis while you’re still alive. When you pass, your family will still receive a tax-deferred death benefit, albeit a lower one than the maximum death benefit plan.
Many find this plan to be the best of both worlds. They have to take their RMDs but don’t need the money for income purposes. Since they’re over age 70, they want to have less risk. Instead of putting the after-tax money into the market, they can place it in a life insurance product where they still have access to the cash value.
Direct and non-direct recognition
Like anything else, it’s vital to have a professional help with this type of legacy planning. Not all life insurance products and carriers are equal.
A 45-year-old doctor to set up a permanent life insurance plan. He was considering another product with a reputable life insurance company, but that strategy wouldn’t work for him. Why? Because, in his current financial situation, he desired to have access to a policy loan that wouldn’t affect the cash value of his policy.
The particular policy this client was interested in uses a direct recognition loan, which only affects the policyholders who have outstanding loans and would result in a decrease in the cash value of his policy by the amount he receives as a loan. But, with a non-direct recognition loan, the adjustment is spread out among all of the policyholders, resulting in a dividend rate that remains the same and is often lower than a direct recognition loan policy. This allows the cash value to remain the same for those who desire to take out a policy loan.5
Although the IRS lets you borrow money from a cash-value life insurance product without taxation, some companies directly recognize the loan, diminishing your account value. Companies who offer non-direct recognition loans continue to pay the same dividend and/or interest on your cash value, even though you’ve borrowed against it.
That’s why it’s important to find someone who understands the distinctions between companies and products and can help you find a solution that suits your needs.
The IRS requires you withdraw RMDs no matter what. But, the IRS also lets you put your after-tax dollars into a tax-advantaged environment. That way, you can optimize your money for you and your family.
