With the S&P 500 hitting a record high in January, account balances have also reached new highs — and while that may mean a bigger nest egg for some, it could lead to higher taxes and surcharges for older retirees required to withdraw from pre-tax retirement accounts every month.
These withdrawal requirements, called required minimum distributions (RMDs), mean that rising account balances lead to larger withdrawals and, in turn, greater taxable income. This can push people over the age of 72 into a higher income tax bracket or trigger the net investment income tax of 3.8% on returns from interest, dividends and capital gains. Such thresholds can come as an unwelcome surprise — especially for retirees who have more income than they need.
If this sounds like you, there is good news. Working with your own qualified tax professional, here are some ways to consider for allocating the extra income, including strategies that allow you to leave money to loved ones or causes that matter most to you.
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Options to consider:
1. Make qualified charitable donations (QCDs).
With the passage of the federal SECURE 2.0 Act of 2022, individuals over the age of 70½ are eligible to transfer up to $105,000 from an individual retirement account (IRA) to a charity tax-free each year. Referred to as qualified charitable distributions (QCDs), these donations can be leveraged to avoid paying taxes on extra personal income. Eligible charitable organizations, typically 501(c)(3) organizations, also receive tax breaks on QCDs.
Still, you should be mindful of timing in light of the “first-dollars-out rule,” which states that the first dollars withdrawn from an IRA in any year are deemed to satisfy the RMD. Consider taking QCDs at the beginning of the year — before any RMD income is withdrawn — to offset taxable income. Unfortunately, RMD income can’t be offset by a QCD done later in the year.
This option can be suited for those who truly don’t need additional income and are already accustomed to making charitable contributions every year, especially since QCDs are irreversible once they’ve been transferred.
But the returns from QCDs extend beyond financial gains; philanthropic endeavors can advance the causes you care most about, help others in need and set a positive example for your children and grandchildren.
2. Convert pre-tax retirement accounts to Roth IRAs.
If you have retirement accounts with pre-tax contributions that are subject to income tax upon distribution — 401(k)s, traditional IRAs, 403(b)s and other similar plans — you might consider converting them to Roth IRAs, which offer after-tax contributions and qualified tax-free distributions. By doing so, you create an asset that is no longer subject to taxation under RMD requirements.
If appropriate for your individual set of circumstances, there are other benefits from taking this route. For one, all of the growth you see after a Roth conversion is truly yours — meaning you’ll spend less time trying to plan out withdrawals based on current tax policy. And you gain full control over the timing and amount of your own distributions.
The downsides? Well, for any Roth conversion, you’ll have to pay taxes upfront, which can leave you with thousands of dollars less. However, this move can be worth it in the long run.
Keep in mind that it’s important to consult and work closely with your qualified tax professional in determining and carrying out any course of action.
3. Use a life insurance policy to build intergenerational wealth.
If you’re in your 70s, now may be a good time to create as much opportunity for your grandchildren as possible. One way to do that is to take out a life insurance policy on your children that pays out a death a benefit to their children (your grandchildren).
You can start by setting up a trust that serves as the owner and beneficiary of the policy. That trust could then require that certain sums of money be used for specific purposes, such as college tuition or living expenses.
One advantage to considering a permanent life insurance policy is the potential for you to build leverage over time. Since a permanent life insurance strategy oriented around the death benefit hinges on the age and health of those being insured, it’s important to work with an insurance-licensed financial professional in seeking a suitable permanent life insurance policy.
Once a life insurance policy has been established, you won’t be able to withdraw from it like a bank account. So, before you divert your excess income to a life insurance policy, consider whether you may need that money later in life.
Your financial runway should match your needs
It’s easy to see the downsides of outliving your retirement income. But rarely do we expect our money to outlive us — which is what could happen if you save more money than you end up spending.
If you are unsure where you stand at the top of this year, take the time to assess your situation and consider working with financial and tax professionals to see if your nest egg is more than you may need. These strategies can guide you in putting extra funds toward planning your legacy.
This article, which has been obtained from an outside source and is provided as a courtesy by Stephen B. Dunbar III, JD, CLU, Executive Vice President of the Georgia Alabama Gulf Coast Branch of Equitable Advisors, LLC, does not offer or constitute, and should not be relied upon, as financial, investment, tax, legal advice. Your unique needs, goals and circumstances require the individualized attention of your own tax, legal, and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its affiliates do not provide tax or legal advice or services, nor do they endorse, approve, or make any representations as to the accuracy, completeness, or appropriateness of any part of any content linked to from this article. It is not possible to invest directly in an index. Stephen B. Dunbar III offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC. Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. GE-6363158.1(02/24)(exp.02/26)
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