Worried About 2021 RMD Sticker Shock?
by Prof. Robert Bloink and Prof. William H. Byrnes
Many clients have by now placed any thoughts of RMDs firmly on the back burner for 2020. After all, Congress suspended the minimum distribution requirements early in the year in response to the COVID-19 pandemic. Despite this, the fourth quarter is now looming before us—and with that, clients should once again begin thinking of their RMD strategies for 2021. One strategy to help clients avoid 2021 RMD-shell shock involves taking another look at qualified longevity annuity contracts, or QLACs—which can kill two birds with one stone in providing added retirement security while minimizing taxable RMDs in 2021 and beyond.
Unpacking the 2020 RMD Waiver
Anyone who owns a traditional retirement account is subject to the required minimum distribution (RMD) rules. Beginning at age 72 (70 ½ prior to 2020), taxpayers must take taxable distributions from these accounts whether they need the money or not.
Under the CARES Act, passed in response to the COVID-19 pandemic and general stock market instability, Congress suspended the RMD rules entirely for 2020. The suspension applies to all 401(k), 403(b), and certain 457(b) deferred compensation plans maintained by the government, as well as IRAs.
The IRS also allowed anyone who took a waiver early in 2020 to roll the funds back into the account (tax-free) through August 31, 2020. These rollovers do not count toward the generally applicable rule that permits only one IRA rollover per 12-month period.
RMDs, however, are calculated based upon the account value at year-end. Leaving the 2020 RMD in the account means that clients already subject to the RMD rules will be required to take a slightly higher RMD in 2021.
QLACs as a Tool to Minimize Future RMDs
A QLAC is an annuity that is purchased with retirement account funds and held within a traditional retirement plan (whether it's a 401(k), 403(b) or traditional IRA). Annuity payments are deferred until the client reaches old age in order to provide retirement income security late in life (payments must generally begin by the month following the month when the client reaches age 85). The annuity payments are guaranteed, meaning that the client will hedge against longevity risk in addition to reducing current RMDs.
QLACs are useful in retirement income planning because their value is excluded from the overall retirement account value when calculating the client's required minimum distributions (RMDs) once the client turns 72. This, of course, allows the client to reduce ordinary income tax liability once RMDs kick in by reducing the overall account value used to calculate annual distributions.
Clients are limited to purchasing a QLAC with an annuity premium value equal to the lesser of (1) 25 percent of the account value or (2) $135,000 (as adjusted for inflation in 2020).
Most 401(k)s do not currently allow QLACs to be purchased within the plan. However, clients may be able to take an in-service distribution to move funds into an IRA (or simply transfer the funds to an IRA in a non-taxable transaction if they have already retired).
When it comes to the QLAC itself, clients have the option of choosing a joint payout option to benefit a surviving spouse or a lump sum distribution to beneficiaries if the QLAC payments are never needed. Once QLAC payments begin, the amounts are subject to ordinary income tax just like any other retirement account distribution.
The client does not have to wait until RMDs kick in to purchase the QLAC—although the client is permitted to buy the QLAC after reaching age 72.
Conclusion
Roth conversions also offer a way for clients to reduce RMDs in later years—although for many clients, recent market uncertainty has drawn attention to the attraction of creating a stable source of income for retirement. Given the turmoil of the times, pre-retirees and younger retirees may now be especially attracted to the idea of minimizing income taxes early in retirement to provide stability later in life via the QLAC structure.