What is RMDs and how does that affect me?
In my first career, I was a Naval Intelligence officer serving on an aircraft carrier. Aircraft carriers are interesting vehicles: 90,000 tons of steel with 8,000 crew members, 500 of whom are officers. It takes the power of a fully-functioning nuclear power plant to maneuver this leviathan through the water, and the electronic bandwidth of your home is allocated to allow satellite communications and radar functionality on these crafts. With these limited resources, these ships navigate treacherous waters in service to the strategic, operational, and tactical objectives decided by people paygrades above anyone sailing on these crafts. This situation is very similar to the one in which we find ourselves in the 21st century economy. Navigating the economy can only be accomplished through the help of an intelligence officer.
I am sure you have been told, at various stages of your career, to participate in your company’s 401(k) or to set up an IRA. Deduct your contributions from your taxable income and pay less in taxes while you work. Let that money grow in a securities-based account. Don’t worry about paying taxes on any of that growth. You won’t have to pay taxes on it until you decide to take distributions. Under current law, you are not even allowed to start taking distributions until age 59.5 without incurring a 10% tax penalty. Besides, once we retire, we won’t be earning as much income, so even if our distributions will be taxable as ordinary income, the prevailing idea is that our marginal tax rates will be so much lower. Consider the marginal tax rates as outlined below.
Since all the funds in 401(k) and IRA accounts are subject to ordinary income taxation, we have an incentive to keep the money in those accounts and not spend it unless we need to, lest our marginal tax brackets increase based on whatever we distribute. Once you reach the age of 70.5, however, leaving all of your money in these accounts is no longer an option.
Once you turn 70.5, Uncle Sam stipulates that you are required to take what are known as Required Minimum Distributions (RMDs). In order to determine the size of a person’s RMD for any given year, everyone’s favorite 3-letter federal agency, the IRS, puts out an RMD worksheet. You can download it from this website.
In order to get a sense of how an RMD scenario might play out, let’s say that we have a relative who turns 70.5 before April 1 this year. That person has until December 31 of 2019 to deduct that RMD from his IRA. Let’s say the balance on that account is $500,000. Your relative has to divide that balance of $500,000 by the distribution period listed next to his age, which is the life expectancy factor calculated by the IRS. Let’s say that that number in this case is 27.4. $500,000/27.4 = $18,248.18. That is how much your relative is required by law to distribute from his account, and that amount is then added to his taxable income for 2019. Failure to take your RMD results in a 50% tax penalty. That is, you would pay 50% more in taxes on the distribution that you were required to take.
Of course, this is the MINIMUM that you MUST withdraw that year. You are ALLOWED to make as large a withdrawal as you want, starting as early as age 59.5. Of course, Uncle Sam wants you to withdraw as large a chunk as possible because the larger your withdrawal, the larger your tax rate.
Now, for those who are frugally-minded, there is a strong probability that these IRAs or 401(k)s are meant to not only provide a secure nest egg to hold them through retirement, but also to hopefully leave a little to pass on to the next generation. This is where things get very interesting.
The SECURE Act and What it Means for Your Heirs
On May 23, 2019, the House passed the Setting Every Community Up for Retirement Enhancement Act, better known as the SECURE Act. If this act clears the Senate, you can expect all of the following to happen.
- More part-time workers to have the opportunity to participate in a 401(k) plan;
- The chance to contribute to traditional IRAs for as long as desired;
- The minimum distribution age for retirement accounts to shift from 70 1/2 to 72 years old;
- Penalty-free withdrawals to be allowed for special circumstances; and
- A requirement to withdraw from inherited retirement accounts within 10 years.
The most significant takeaway is the requirement to withdraw from inherited retirement accounts within 10 years. This is Uncle Sam making a naked tax grab. Prior to the passage of the SECURE Act, when a person inherits a tax-qualified account such as an IRA or 401(k), the heir has the remainder of his/her life to distribute the funds within the account, in order to control his/her marginal tax rate. This is known as a stretch period. What the SECURE Act has done is to condense that “stretch period” down to 10 years. Typically, the heir of an account like this is in his/her forties and fifties, working, and putting a child through college. Now, they have to liquidate that IRA at 10% per year, which increases their marginal tax rate by that amount as well. And to add insult to injury, the entire pre-tax balance is added to their net worth when determining their child’s eligibility for need-and-merit-based scholarships, loans, and grants for college.
This tax grab comes as Uncle Sam finds himself 22.5 trillion in debt and with a downgraded credit score. This happens as the elderly population in America is becoming the fastest-growing demographic. Today, 1 in 7 Americans is over the age of 65. By 2040, this will be 1 in 5. This population faces the ever-present threat of outliving their assets, while still being motivated by the desire to leave behind a legacy and not a burden, taxable or otherwise.
At US Vet Wealth, our outside-the-box process has found a way to allow you to comfortably fund your retirement and leave behind a financial legacy. We call it the Qualified Reset Plan.
Retirement Wild Cards
What follows is an example of an actual client who used our solution. To protect his privacy, his name and any identifying details have been changed.
John Smith is 60 years old. He is a corporate attorney, but not sure when or if he can or should retire. He contributed well to his 401(k) over the years and has accrued $1,050,000. He does not have a pension. He wants to make sure that his 401(k) lasts. He anticipates that he needs just over $100,000 per year to live comfortably. If he hopes to liquidate his $1,050,000 account and use it to cover his needs beginning when he reaches the age of 70, assuming an S&P 500 average rate of return of 6.5%, he MAY accumulate enough funds to retire by 70. However, he would have to withdraw significantly more than $150,000 out of his account every year just to have $100,000 in his pocket. Now there are two wild cards that will affect the accuracy of what I am showing you here.
The first is the rate of return on John’s 401(k). If the S&P 500 continues at its average rate of return of 6.5%, then John can expect his account value to be about $1,690,893 by the time he turns 70. However, this AVERAGE rate of return does not mean that John can expect a 6.5% return every single year. It operates in 6-year-cycles, with a bear market turning up every 6 years on average. I have no idea—nor does anyone else—which of those years will turn up a bear market.
The second wild card is the marginal taxation rate. While what I am about to present is an extreme example of a future tax hike, we do not have to be geniuses to know that a tax hike is coming, and it’s important to see what a substantial tax hike will do to John’s retirement plan if he continues along the default path, and how our alternative will mitigate these effects.
Assume that taxes are as low as they will ever be for the time being. Now consider John’s marginal tax rate jumping from 22% to 40% on his account within the next 10 years. As stated before, in the best case scenario, John’s account will have a balance of about $1,690,893 by the time he turns 70, which means that he will need to take withdrawals of $169,000 just to have $100,000 in his pocket each year. I illustrate John’s situation in this way to make 3 important points:
- If the securities market takes a turn during the first few distributions or during the last few years of accrual, John’s account could be severely depleted, and his distributions would still be taxable as ordinary income;
- If John lives to the age of 90, he risks being taxed or spent down to $0; and
- If John passes away with undistributed cash, whatever he leaves behind to his heirs will be heavily taxed.
Now, you may ask yourself how much of this is avoidable and what John can do to prevent it. The answer is 100% of these risks can be prevented.
The Qualified Reset Plan Solution
In our case study here, John, wanting to give himself a definitive work force exit strategy, resolves to liquidate his 401(K) over a 7-year-period while he is still working, so he contributes $150,000 per year to The Qualified Reset Plan. The distributions from his 401(k) would result in $30,000 per year in income taxes under the current marginal tax rates. He would use a participating loan to withdraw $30,000 from his Qualified Reset Plan to satisfy his tax obligations for these 7 years.
With the Qualified Reset Plan, we are basically dealing with three different pots of money: the Accumulation Value, the Surrender Value, and the Death Benefit. The Accumulation Value is the total amount of funds that have been contributed to the account. It is does not take into account distributions or loans. The Surrender Value is the amount of liquid capital available for tax-free withdrawals. The Death Benefit is the amount to be paid to heirs upon the death of the insured.
In our scenario, after taking the 7 years to fund his plan, beginning at age 70, John is able to withdraw approximately $100,000 a year in participating loans, tax-free, for the rest of his life, no matter how long he lives. These participating loans are borrowed against the surrender value and paid back by the death benefit.
But it gets even more interesting. The rate of return on this Balanced Growth Accumulator is calculated based on the accumulation value and then fed back into the surrender value. This allows Mr. Smith to earn returns, and pretty healthy ones, on the money that he had to pay in taxes. And because this is an Indexed Universal Life Insurance policy, the cash value is protected against losses due to market volatility, which means that returns, once credited to his account, are his to keep.
From age 70 ad infinitum, when his colleagues are exercising their RMDs and praying for bull markets, John will have $101,734 annual pension that he can draw at will, with no taxes, for the rest of his life. Whenever he passes away, the death benefit that he passes to the next generation will be 100% tax free as well.
Using the Qualified Reset, John has found a way to disinherit Uncle Sam. There is NOTHING preventing any of us from doing the same. The most important takeaway is that the balance in that account is not nearly as important as the amount that you can ACTUALLY SPEND.