The IRA minimum withdrawal predicament is a hot topic for financial advisors with affluent clients who are at least 701/2 years old, yet don’t need the income from required withdrawals. Today, financial advisors may consider a broader range of options to maximize total return and minimize tax consequences for their wealthier clients.
Often under a tax advisor’s direction, many clients have used IRAs successfully as a primary vehicle for retirement planning. However, if the client has built fairly significant wealth prior to age 701/2, the required minimum withdrawals may seem like a penalty for years of saving instead of a reward. The reality for the affluent is that IRAs are inefficient vehicles for tax purposes. For some, the withdrawals bump the client into a higher tax bracket and may result in an undesirable taxation of Social Security income. Many simply don’t need the money and would prefer to use it toward building an inheritance for the next generation. Many advisors ignore their clients' dilemma and overlook an opportunity to provide valuable guidance.
What creative solutions can the advisor propose to address this IRA minimum withdrawal conundrum?
1. Survivorship Life Insurance Funded By Fixed-Index Annuity With An Income Rider
Instead of putting these funds into another taxable account, the client may use his or her required minimum distribution to fund survivorship life insurance. The ideal scenario for many affluent couples is a two-step process. First, the advisor can suggest transferring the money from an IRA into a fixed-index annuity. The interest earned by these annuities is tied to a stock market index such as the S&P 500. Along with providing a steady income stream for life, this investment vehicle protects the client from stock market volatility. At the same time, it protects the client from interest rate volatility. Second, the income from the annuity can fund the premiums for survivorship life insurance. This specialized insurance would enable tax-free dollars to flow to the clients’ children and grandchildren or other heirs. Designed primarily for married couples in their sixties and seventies, survivorship life insurance pays after the death of both individuals. Therefore, premiums are more reasonable than single life insurance policies. Life insurance is the only vehicle that can be passed income tax free to beneficiaries.
It is important that clients first understand the survivorship life insurance challenges. First, the policies pay no benefit to the current spouse. However, if the senior couple maintains a high net worth, there is not often a need for a pay-out after the death of one partner. The other hurdle is that unlike other investment vehicles, the client must qualify for survivorship life insurance with a physical exam. At least one spouse must be in generally good health to secure the insurance at a reasonable premium. Even if one spouse is uninsurable, the couple can still qualify for life insurance. Securing survivorship insurance can work for couples in their eighties as well if at least one of the partners qualifies.
The advisor can arrive at the amount of survivorship insurance to be secured in two ways: one is to apply for the face amount for which the IRA would be taxable to children; and the second is to calculate the income after taxes from the IRA annuity and match it to how much survivorship life insurance it would fund.
2. Conversion To Roth IRA
For certain clients, the conversion of an IRA into a Roth IRA is another alternative. This is especially the case for those clients who have huge amounts of capital loss whereupon conversion of a traditional IRA to a Roth IRA would eliminate the tax due against capital loss. If the client has been subject to bad market conditions or unfavorable investments, conversion is likely a preferable scenario. Clients should understand that they must hold the ROTH IRA for at least five years --and not die – or it reverts to a traditional, taxable IRA.
3. Donate To Charities And Pass Tax-Free Income To Heirs
A final option is related to legacy planning. Clients may donate the IRA withdrawal to charities or pass it along as tax-free income to heirs or other beneficiaries. If a client wishes to give to a qualified charitable organization, using the IRA income to fund the donation is a tax-efficient way to build a legacy or simply fund a nonprofit commitment. In addition, clients may gift up to $14,000 per person or $28,000 per couple each year to as many individuals as desired. This is another way to reduce taxation and efficiently use the required minimum withdrawal.
David Kanani is a financial advisor and president of Kanani Advisory Group in Irvine, Calif. He provides retirement and estate planning services to individuals 55 and up.