On July 1, the first baby-boomer turned 70½, the first of tens of millions who will become subject to dreaded required minimum distributions, or RMDs, from their individual retirement accounts or company plans.
The word “required” is upsetting to most clients, since it means they are now being forced to begin emptying their IRAs, albeit at a slow pace. For most clients, RMDs will begin at less than 4%. But still, most clients don't like being forced to take RMDs, because they generally don't need the money and it increases their tax bills each year.
What to do? The RMD still has to be taken, so why not put it to good use creating future tax-free benefits.
A common question from advisers is, “Can the RMD be converted to a Roth IRA?” The answer is no. Under the tax law, an RMD cannot be rolled over, and a Roth conversion is a rollover from an IRA to a Roth IRA.
However, the RMD, if not currently needed for retirement income, as is often the case, can be used to convert other IRA funds to a Roth IRA, and keep those funds growing tax free and free of future RMDs.
Example: Mary has a $411,000 IRA and is now subject to RMDs. Mary's 2016 RMD comes to $15,000. That amount must be withdrawn and cannot be rolled over or converted to a Roth IRA.
Mary will owe tax on the $15,000 RMD, but now can use that money to do as she pleases, because it is no longer IRA money. If Mary does not need the money, and she wants to put it to good use, she can use it to convert part of her remaining IRA balance to a Roth IRA. This would build a Roth IRA, which is not subject to RMDs for her lifetime, and it can lower her future RMDs from her IRA.
GIFTING AN RMD
However, at age 70, Mary may not be a good candidate for a Roth conversion, unless the intent is to leave it to heirs. In that case, a better option might be to gift that RMD amount to children or grandchildren to use to contribute to their own Roth IRAs or to pay the tax on converting their own IRAs to Roth IRAs. They may be in a lower tax bracket and have a longer time horizon to create more tax-free wealth. In addition, they will not be subject to RMDs on their own Roth IRAs as they would be if they inherited a Roth from Mary.
Mary's RMD will be subject to tax anyway, but that RMD can be used to build more tax-free savings for her or her children or grandchildren while taking the risk of future higher taxes out of the equation for a generation or more.
Mary could also use that $15,000 RMD (or what's left after the tax on that withdrawal) to contribute to a Roth IRA if she qualifies. To qualify, Mary must be working and her income cannot exceed the Roth IRA contribution income limits. There is no age restriction to contributing to a Roth IRA as there is for making traditional IRA contributions. Those cannot be done for the year the IRA owner turns 70½ or later.
The $15,000 RMD can also be leveraged by using it to fund a permanent life insurance policy that can double as a retirement account to be accessed tax-free during her lifetime.
That policy can also include a long-term-care insurance rider creating another lifetime benefit. If it turns out that Mary does not need to tap into the insurance funds, they will provide a highly leveraged tax-free windfall for her heirs, from that once dreaded RMD.
One additional option for Mary's RMD is to give it to charity. The qualified charitable distribution (QCD) provision is now permanent.
If your client normally gives to charity, the QCD is a more tax-efficient way to do that. The funds still go to the charity, but the tax cost is less.
If Mary normally gives $10,000 a year in donations, she would be better off tax-wise using the QCD to make direct transfers of $10,000 from her IRA to qualifying charities. This eliminates $10,000 of RMD income from her tax return, and can reduce the related loss of deductions, credits and exemptions that can result from higher income.