Let’s Remove the Confusion around RMDs
RMDs are difficult to understand. Annuities are complex and intricate. Put them together, and it can be an elaborate challenge to figure out where your money is, where it’s going, and how you can benefit from using it in your retirement.
So let’s take a simple approach to understanding RMDs and annuities, their relationship, and the best options for your retirement needs.
What is a required minimum distribution (RMD)?
An RMD starts to take effect when you reach age 70 1/2 (when was the last time you celebrated your half birthday?). It’s the minimum amount you’re required to withdraw from your retirement plan each year. This can apply to 401(k)s, profit-sharing plans, 403(b)s, 457(b)b, and traditional IRAs, including SEP and SIMPLE. It does not apply to Roth IRAs, but it does apply to Roth 401(k)s.
Why do you need to start withdrawing from your retirement account? The government wants you to start paying taxes on that money. The money that put into your retirement plan through your employer was likely submitted before income tax was applied. That means that the IRS is “out” of their owed taxes from that part of your income. At age 70 1/2, they remind you that it’s time to pay up.
The way you pay these taxes is by withdrawing a percentage of your pre-tax IRA or 401(k) accounts. That percentage is your required minimum distribution. You then pay income tax on that required minimum distribution (aka the amount that’s withdrawn). Basically, you have to take money out of your retirement account so the IRS can tax you on that income.
How is a required minimum distribution calculated?
How much do you need to take out of your account each year to meet the minimum requirement? The RMD number is calculated with two key factors: your retirement plan balance and your life expectancy.
First, they will look at the balance of your retirement plan (IRA or 401k, for example) from the previous December 31. This is considered the “value” of your plan for the year.
Even if you have multiple retirement plans, these will be totaled together to calculate the RMD you need to take out. For example, you have $100,000 in IRA (x) and $200,000 in IRA (y). Your RMD will be calculated for the amount of $300,000 total. You can withdraw your RMD amount from the IRA(x), IRA(y), or a mixture of the two—as long as you withdraw the full RMD from somewhere.
Then, that balance from 12/31 will be divided by your life expectancy factor to give you the RMD calculation. There are three tables that can calculate your life expectancy:
- Joint and last survivor: if the sole beneficiary is a spouse at least 10 years younger than you
- Uniform lifetime table: if the spouse is not sole beneficiary or if spouse is not 10 years younger
- Single life expectancy: if there is only one beneficiary of the account (an inherited IRA, for example)
Don’t worry. You don’t need to calculate the required minimum distribution cost on your own. A financial agent can help you come up with the appropriate RMD number that will make the IRS happy.
What is the problem with an RMD?
There are a few concerns that accompany the required minimum distribution.
The first is that you are held responsible to take out the money every year from your account. You need to be aware of the amount of your required minimum distribution and withdraw it appropriately. If you don’t withdraw the RMD amount, you will face a hefty penalty up to 50% of your retirement plan.
This kind of pressure and stress can be fearful for many retirees. Forgetting to withdraw the RMD even one day after the deadline could cut your lifetime savings in half. You don’t want this responsibility and risk to fall on you.
Secondly, if you are using your retirement plan for you and your family to live on, an RMD can be concerning for budgeting purposes. Once you have gone through your retirement savings plan… that’s it. Every year you take out a certain amount of money, and once that money is gone, you no longer have retirement assets. This can be frightening for retirees who aren’t sure how to budget for an indefinite amount of time.
Additionally, some people may not want to take their money out of their account at all. They may want to leave the assets from their IRA or 401(k) to their beneficiaries as a sort of legacy. The required minimum distribution can cut into this legacy by forcing you to pull money out of the account that you’re holding for your beneficiaries.
Furthermore, the required minimum distribution can impact your investment performance. You are forced to take money out of your savings, which lowers the amount you have invested; this, in turn, lowers the amount of your potential compounded earnings.
If you’re thinking that you’ll just rollover your retirement plan to another tax-deferred account, that wouldbe smart…but you can’t. You have to start paying taxes on that money.
Annuity strategies can help address these required minimum distribution concerns.
What is an annuity?
An annuity is a retirement plan that will pay you a monthly income for the rest of your life. You’ll purchase the annuity and input funds during the “accumulation phase.” You will later receive a certain amount of money each month during the “annuitization phase.”
With an annuity, you are guaranteed an income for the rest of your life, which can help protect against longevity risks (the fear of outliving your assets). There are a number of annuity intricacies, but the three major types are immediate, longevity, and deferred variable.
How are an annuity and RMD related?
An annuity is a longer-term solution for withdrawing money that doesn’t bring with it the risk of missing a withdrawal or the rules and regulations of an IRA or 401(k).
Many individuals will use all or a portion of the money from their IRA or 401(k) to purchase an annuity. It makes sense to do this before the RMD takes effect at age 70 1/2 to avoid any confusion or penalties. However, it is still possible to purchase an annuity after you are withdrawing RMDs.
The three types of annuities each have their own relationship with the RMD.
1. Immediate annuity
An immediate annuity instantly creates a stream of payments upon purchase of the annuity plan. These payments continue for the rest of your life expectancy.
If the amount of these payments totaled annually equals the amount that would be your RMD, you don’t need to worry about your RMD. The RMD does not apply to annuity holdings.
Say, for example, you have $300,000 in your IRA. You use $100,000 to buy an immediate annuity. That $100,000 is no longer calculated in the total required minimum distribution you will have to pay. However, you will still have to withdraw the RMD amount for the remaining $200,000.
If you use the entirety of your IRA to purchase an annuity (after age 59 1/2), then your annuity’s monthly payments will equate to your RMD. Subsequently, you will not have to withdraw any additional money and are not subject to the required minimum distribution.
There are two main reasons that an immediate annuity “exempts” you from the required minimum distribution for that amount of money. You are paying upfront to a company that invests it and will later make you future payments. You’re not actually holding any money in the bank. You couldn’t withdraw a lump sum payment if you wanted to. So there’s nothing really to “withdraw.”
Secondly, immediate annuity is usually non-increasing. You will get the same level of payments each year for the rest of your life. Required minimum distributions actually increase proportionally to the total value of your holdings. So a level annuity can’t fit the formula of an increasing RMD.
In essence, any money in an immediate annuity is exempt from the RMD withdrawal.
2. Longevity annuity
You buy a longevity annuity now and start receiving payouts later. You can buy it with the money from your IRA—up to 25% of your retirement account assets or $125,000 (whichever is less).
Like the immediate annuity, any money that is in the annuity as opposed to the retirement savings plan will not be included in the RMD. RMD is based on non-annuity holdings.
As long as your longevity annuity starts paying you out by the time you are 70 1/2, it works in a similar way as the immediate annuity discussed above. If you don’t start receiving payouts by the time you are 70 1/2, you’ll be in a situation similar to the deferred variable annuity.
3. Deferred variable annuity
The deferred variable annuity is a bit trickier with regards to the RMD. For this, the value of the annuity is dependent upon whether or not it has been annuitized.
If it has not yet been annuitized when you turn 70 1/ 2, it’s considered an asset that you’re holding. You aren’t paying any income tax on it because you aren’t withdrawing anything. In this case, your RMD calculation will take into account a non-annuitized annuity.
If you are taking payments from your annuity by the age of 70 1/2, you’re paying income taxes on it. Thus, it’s not included in your RMD. (Similar to the immediate annuity.)
If you start taking payments after the age of 70 1/2, that annuity will no longer be considered part of your RMD calculation. You will satisfy the required minimum distribution for the annuity’s value with the payments.
If you annuitize after your RMD has taken hold, be careful with your calculations the first year. Talk to a financial agent who can help you determine the appropriate calculation.
P.S. A great way to ensure you have a legacy for your beneficiaries is with an annuity death benefit rider. This will grow your annuity money to help offset the required minimum distribution you pull out of any accompanying IRA.
Required Minimum Distribution Bottom Line
In essence, annuities are not calculated in the RMD calculation when they are giving you payments. If they are not yet annuitized, they are still considered in the required minimum distribution calculation.
Note that any money that is still in your retirement account will still have a required minimum distribution associated with it. You can’t use an annuity payout to offset the withdrawal from an IRA or 401(k).
This is a confusing, intricate process. If not handled correctly, you could lose half of your entire life savings in penalties. You could be left without security for you and your family. Contact Sunpath today to start discussing your options to offset a current or future required minimum distribution.