How to put your RMD to work (and avoid a 50% penalty)
It's that time of year again, the time when people 70 and up are scratching their heads about RMDs — required minimum distributions.
At age 70½, holders of non-Roth individual retirement accounts are required by the IRS to begin withdrawing money from those accounts every year. Most people take this distribution in November or December, and if they don’t get it over with, they’re on the hook for a 50% penalty. While some people may need these distributions to supplement their retirement incomes, for many that's not the case.
“A lot of our clients just go through the act of taking it out because they have to,” said Bill Van Sant, senior vice president of Girard Partners, a Univest wealth management firm. Such retirees can get creative with it instead, he said. They can reinvest their money or grow it for the sake of their families. One option Van Sant recommends to retirees is municipal bonds. While they do not accrue as much interest as other investment vehicles, they are tax-free.
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Jamie Hopkins, associate professor of taxation at The American College of Financial Services, said a qualified longevity annuity contract (QLAC) can reduce the money retirees pay in taxes from RMDs. The money put into the QLAC — up to $125,000 — does not count in the IRS’ calculation of RMD taxes, and the money can stay safely in a QLAC until age 85.
The drawback, Hopkins said, is the retiree loses growth potential with that money in the intervening years — and they must be confident they’ll live long enough to access the money again. “If I don’t live a long time, it’s not a good deal from an investment perspective,” Hopkins said.
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Those concerned with what they will leave to their families may want to consider investing in insurance, said Keith Moeller, wealth management adviser for Northwestern Mutual. A term life policy will not have as great a payout as if the policyholder was in their 30s, but it can create a bigger payout for family members than some investments. A permanent, or “cash value,” plan has the added benefit of a cash value that builds up over time, Moeller said.
Retirees should talk to tax planners before considering these plans, but the benefits can be potent, he said. The liquidity they offer can allow surviving spouses to convert traditional retirement accounts into Roth IRAs. Surviving children can take "stretch" Roth IRA distributions, gaining a lifetime of tax-free income, Moeller said.
RMDs are also an opportunity for charitable retirees to give. They can channel money directly from their retirement accounts to charitable institutions. Retirees can also put the money into a 529 college savings plan for their grandchildren, Van Sant said.
The RMD process, initially a grudging transaction, becomes a chance to build a legacy. “My clients have that moment where they say, "I kind of get this. This is an opportunity for me,” he said.
What to know about RMDs
When do you need to take them? The calendar year in which you turn age 70½, but the first payment can be delayed until April 1 of the following year.
Which retirement accounts require RMDs? IRA, SEP IRA and SIMPLE IRAs and traditional 401(k)s require RMDs. Roth IRAs do not require withdrawals until the owner dies.
How much will I need to take out? The older you get, the higher the RMD will be. Find an estimate using an online calculator such as the one by the Financial Industry Regulatory Authority at finra.org.
SOURCE: IRS.gov; FINRA