Have you used a traditional IRA to save for retirement? If so, you’re not alone. Traditional IRAs are among the most popular retirement savings vehicles. Much of their popularity is due to their unique tax treatment. You can deduct your IRA contributions, and all growth is tax-deferred as long as it stays in the account.
Of course, you can’t avoid taxes on your traditional IRA growth forever. Distributions from your traditional IRA are treated as taxable income. That means that in retirement, your traditional IRA income could create a tax liability and possibly even push you into a higher tax bracket.
Some people delay traditional IRA distributions to avoid the tax hit. However, the latest you can delay your distributions is to age 70½. At that point, you have to begin taking required minimum distributions (RMDs).
Your RMD is based on the balance in your account and your age. The older you are, the larger the portion of your balance that you’ll be forced to withdraw. The distributions are taxable, and if you don’t take your RMDs on time, you could face substantial penalties.
While you can’t avoid your RMDs, you may wish to avoid the tax liability that comes with them. With careful management and planning, you can minimize your tax exposure. Below are a few strategies to consider:
Use life insurance loan distributions to cover tax liability.
Do you have a permanent life insurance policy that has accumulated significant cash value? Do you feel you may not need as much life insurance protection as you once did? If so, you might want to consider using some of that cash value to supplement your retirement income, perhaps even to pay the taxes on your RMDs.
You can take a tax-free distribution from your life insurance policy in the form of a loan. You borrow the funds from your cash value, with the understanding that you will repay the funds back into the policy. If the loan isn’t repaid before you pass away, it’s simply deducted from your death benefit. You could use this strategy to generate tax-free income to pay your RMD tax liability.
Convert to a Roth to avoid RMDs.
Another option is to convert your traditional IRA to a Roth IRA. In a Roth IRA, your distributions are tax-free and there are no RMDs. You have to pay taxes on the traditional IRA balance at the time you execute the conversion. However, it could be worth it if you have time to let the funds accumulate in the Roth and if it helps you avoid years of RMDs in the future.
Keep in mind that Roth distributions are tax-free only if you are over age 59½ and if the Roth has been open for at least five years. If you need income within the next five years, a Roth conversion may not be right for you.
Reduce your tax exposure from outside income.
Finally, you could implement some detailed tax planning to reduce tax exposure in other areas. As mentioned, life insurance distributions can be tax-efficient. Some types of bonds, such as municipal bonds, produce tax-free income. You might also consider taxable accounts in which you would pay lower capital gains rates instead of ordinary income rates. A tax professional can analyze your situation and make specific recommendations.
Ready to develop your RMD strategy? Let’s talk about it. Contact us at Grand Canyon Planning Associates. We can help you analyze your needs and develop a plan. Let’s connect soon and start the conversation.