Talk with clients about a long-term, multi-year strategy to reduce IRA balances by leveraging low tax brackets each year with voluntary IRA distributions, paying taxes when rates will be lower.
Roth Conversion Advantage
Voluntary (pre-RMD) withdrawals can be converted to Roth IRAs, allowing the funds to grow income tax free for the rest of the client’s life, and 10 years after that for their beneficiaries. Roth IRA owners are not subject to lifetime RMDs.
Once clients reach their RMD age at 72, Roth conversions become more expensive since RMDs cannot be converted to Roth IRAs. The first dollars withdrawn from the IRA in an RMD year will be deemed to satisfy the RMD. Once that amount is met, part or all the remaining IRA balance can be converted for that year. But then next year, the same RMD issue returns, unless the entire IRA was converted in the prior year. While RMDs cannot be converted, those RMD funds can be used to pay the tax on converting the remaining IRA funds to Roth IRAs.
The more IRA funds that are converted to Roth IRAs, the less future IRA RMDs will be. That can provide a lifetime of tax savings, both for clients and their beneficiaries, even after paying tax upfront. It’s all about the tax rates, now versus potentially higher rates later.
Life Insurance
For the right client, IRA withdrawals can be taken, again at low rates, and the net after-tax funds can be used to purchase life insurance (permanent, cash value life insurance – not term). The cash value can grow tax free and be available if clients need to tap those funds in retirement.
Like the Roth conversion, using voluntary IRA withdrawals for life insurance allows the funds to be immediately transferred into income tax free vehicles. This serves as a bulwark against the risk that future higher taxes will decimate tax-deferred retirement savings that are left to grow. In fact, when tax rates increase, anything tax free becomes immediately more valuable. Tax-free funds are not vulnerable to future tax risk.
QCDs (Qualified Charitable Distributions)
IRAs are the best assets to give to charity since they are loaded with taxes. Most clients who normally give to charity are no longer getting tax benefits for these gifts because they take the higher standard deduction rather than itemizing their deductions.
QCDs are direct transfers from IRAs to qualified charities, limited to $100,000 per year, per person (not per IRA). Following the same theme of reducing IRA balances when tax rates are low, a QCD allows IRA funds to be distributed at a zero percent tax rate. Plus, QCDs can satisfy an RMD. Not all clients qualify though, so identify those who do and have this conversation with them. QCDs are only available to IRA owners or beneficiaries who are age 70 ½ or older. They are not allowed from company plans like 401(k)s.
The QCD is an exclusion from income, which is a better tax deal than an itemized deduction because the exclusion reduces adjusted gross income. For clients who qualify for QCDs, have them do their giving from their IRAs. They’ll not only receive a tax benefit for their gift, but they will also be reducing their IRA balance at a zero-tax cost.
IRA Estate Planning - Leaving IRAs to Charity
While QCDs from IRAs are good for lifetime giving, IRAs are also the best assets to leave to charity at death for those who are charitably inclined. IRAs can be left directly to a charity. The estate will receive a charitable tax deduction reducing estate tax exposure.