Unicorns, First World Problems, RMDs and the Charitably Inclined

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1 March 2017 Unicorns, First World Problems, RMDs and the Charitably Inclined Back in the late 1980s, Individual Retirement Accounts ( IRA ) with assets greater than $100,000 were considered Unicorns due to lower nominal salaries and the restrictions on the dollar amounts that could be contributed to these types of arrangements. Also, most corporations were still offering traditional pension plans, and Wall Street hadn t really made its way to Main Street yet. This would soon change when industry visionaries like Marty Zweig (a former employer of mine) brought the concept of planning with IRAs to the masses through his appearances on the Lou Rukeyser show and bestselling book Winning with NEW IRAs published in The popularity of these tax deferred retirement arrangements offered by employers and utilized by employees of every type of entity from giant conglomerates to single member LLCs has grown exponentially over the years. We also just experienced the greatest period of wealth creation in human history over the past 30 years, and the assets allocated to these arrangements have ballooned. It is almost the norm now for the typical household, with one or two working spouses, to have tax deferred retirement accounts with aggregate assets in the range of $600k to $2 million. The good news is that many investors who have used these savings vehicles should be able to enjoy a comfortable retirement; however, we note two First World Problems with the large balances that have accumulated in these qualified tax deferred accounts: Problem One Methodology : The investing/saving methodology used by the typical household over the past 30 years to invest, either on their own or, in many cases, by following the advice of an advisor, was to throw as much money into a qualified tax deferred account on a pre-tax basis each year. The problem is that these investors did not account for the fact that many of them would wind up in the same or a higher tax bracket in retirement than during their working days. We believe, and can quantify, that many of these investors may have been better off on an after-tax retirement income perspective if they had (gulp) paid taxes and invested some of these savings

2 dollars into taxable accounts and Roth IRAs in conjunction with the tax deferred accounts. We will expand upon on this topic and explain how investors can try to implement the lessons learned from the past into today s financial planning and portfolio construction process in a future article. Problem Two Uncontrollable : Upon reaching the age of 70.5, many retirees have too much uncontrollable and, in many cases, superfluous income. What do we mean by Uncontrollable, and what is causing it? The owners of these outsized tax deferred accounts are forced through threat of a significant tax penalty for failing to comply to take an annual withdrawal from the tax deferred account until either death or the account is depleted (hopefully the account being depleted doesn t cause the other event). For perspective, for the first 15 years after reaching the age of 70, on average, about 4.8% of the prior year s ending balance must be withdrawn from the IRA via the well-known Required Minimum Distribution ( RMDs ) process. The government, the silent partner to the tax deferred account holder, forgoed taxing the income years prior, allowed the owner of the account to take all of the investment risk and now demands that the piper is paid by taxing the tax deferred account s distributions from the RMDs. For many Families the aggregate amount of what government forces them to withdraw from the tax deferred accounts in conjunction with their Social Security Benefits and other sources of income is greater than what is needed to fund their annual retirement expenses. In retirement, the goal is to produce just enough income each year to fund expenses and minimize the draw down on balances that are needed to fund the retirees Golden Years. Why are the RMDs such a problem? RMDs increase marginal tax rates, create unexpected tax burden on other sources of income like hard-earned Social Security benefits (yes, you may have to pay tax on Social Security benefits, and it can be as much as a tax on 85% of the benefits received), can increase the cost of Medicare, and limits choices for generating retirement income from other sources, such as borrowing money, which may be cheaper and more tax efficient.

3 Example of RMD Problem: If you had a choice and you needed to access an extra $25,000 after the age of 70, would you rather: Option One: Borrow money from the bank, pay a loan rate of 2% to 3% a year ($500 to $750 cost of funds) and wait for a liquidity event like the sale of a home or death to pay off the loan? Option Two: Withdraw more money from a tax deferred account that may cost the owner anywhere from 15% to 39.6% depending on the account owner s tax bracket ($3,750 to $9,900 cost of funds)? In many cases, the investor is already forced to withdraw the $25,000 via the RMD and never has the opportunity to explore the benefit that other sources like borrowing may provide in retirement (yes, it is true that wealthy people borrowing money in retirement can be a very good idea no matter what the book you read states). The forced annual withdrawals via the RMD process is the main problem caused by these ballooned balances in the tax deferred accounts as they limit choices and the opportunity for smart planning. Here is another way to think of the superfluous income: For a Family with $900k in tax deferred accounts and two Social Security benefit payments, not accounting for any other sources of income, the Family is already generating about $110,000 of income ($44,000 of RMDs + $2,600 x 2 x 12 months of Social Security Benefits) in a very tax inefficient manner. Most people would agree that they could lead a very comfortable retirement on $110k a year, but there are other ways to generate that amount of income that would be taxed in a much more efficient manner if not for the fact that so much money is parked in these deferred accounts. There are planning methods that allow an investor to limit the annual tax impact of RMD. Some are simple powerful ideas, and some are complicated awful ideas. We will touch on the simple idea today, and please review our future article that will analyze ( QLACs ) or Qualified Long Term Annuity Contracts that, in our opinion, are complicated awful ideas for delaying RMD payments.

4 A Simple Good Idea. For every person that is over the age of 70.5 that is charitably inclined, has a Traditional IRA account, and is collecting Social Security, there is a simple idea that all people fitting this fact pattern should implement. A Qualified Charitable Distribution ( QCD ) is tax planning provision in the IRS code that allows for an IRA owner to donate their RMD, or any amount up to $100,000, directly from their IRA to a public charity. The QCD satisfies the IRA owner s RMD obligation for the calendar year, and more importantly, the distribution is NOT included in the IRA account owner s taxable income. First the process for making a QCD, once an IRA owner has identified a charity to make the donation, the owner will instruct the IRA custodian to take funds from the tax deferred IRA account, create a check for the requested amount and, this is the critical most important part of this process, the check MUST be made payable direct to the charity. The large IRA custodians like Fidelity and Charles Schwab are familiar with QCDs, but it is the account owner s responsibility to make sure that the check is written for the benefit of the charity as failure to do so will disqualify the potential benefit of the QCD. Please keep in mind that the IRA account holder can either have the custodian mail the check direct to the charity or can have the physical check, written out to the public charity, mailed to the IRA owner, and they can personally deliver the check to the charity or drop it into the collection basket. What is the tax benefit? The QCD provides a greater benefit from a tax perspective in comparison to the more common method of depositing a RMD distribution into the owner s checking account and then in a second act contributing the amount to charity. The logical question, why is the QCD better than accepting RMD and making a payment to charity? The offsetting deduction from the charitable contribution offsets the income from the RMD but the RMD distribution is still included in the esoteric Provisional calculation that determines how much of the account owner s Social Security benefits are included into taxable income. Provisional 50% of Social Security Benefits Taxable (including RMDs) Tax Free (includes Municipal Bond but not Roth Distributions)

5 As you can see Provisional effectively is a gross income calculation that does not provide for offsetting deductions like a charitable gift. So if the investor receives the RMD and makes a charitable gift of an amount equal to the RMD, the RMD amount received is still included into the Provisional calculation (i.e. you gave the RMD to charity but the amount of the RMD is still included in determining how much of your Social Security benefits will be taxed). Once the Provisional has been calculated, now we can determine how much of the Social Security benefits received will be included into taxable income and taxed. Amount of Social Secuity Benefits Taxed First $32k Provisional is Exempt $32k to $44k 50% is included in Taxable $44k+ 85% is included in Taxable The beauty and the tax efficiency of the QCD is that the RMD is not included in taxable income or in the Provisional calculation. Effectively, through the QCD, it is as if the tax payer never received the RMD but satisfied the RMD requirement. Sweet, simple and effective planning!! Scenario 1 Scenario 2 Scenario 3 Descriptor Amount Amount Amount Amount Amount Amount Prior Year End IRA Balance $250,000 $250,000 $500,000 $500,000 $1,000,000 $1,000,000 RMDs $12,000 $0 $24,000 $0 $48,000 $0 Qualified Charitable Distribution $0 $12,000 $0 $24,000 $0 $48,000 Social Sec Benefits $64,000 $64,000 $64,000 $64,000 $64,000 $64,000 Provisional $44,000 $0 $56,000 $0 $80,000 $0 % of Soc Sec Benefits Taxed 9.4% 0% 25% 0% 57% 0% Increase in Taxable from RMD Distribution $6,000 $0 $16,200 $0 $36,600 $0 QCD Tax Savings (15% Rate) $0 $900 $0 $2,430 $0 $5,490 QCD Tax Savings (28% Rate) $0 $1,680 $0 $4,536 $0 $10,248

6 Of course, there are always fine points, please review tax advisors for guidance and advice. Here a few tax planning caveats for a QCD: If structured correctly, the QCD should satisfy the requirement for the RMD for the tax year. At the time of the QCD, the tax payer must already have had their 70.5 birthday, not just make the QCD in the tax year the IRA owner payer has attained the age of 70.5 (this is critical and, to point out, odd). o If QCD occurs prior to the age of 70.5, the QCD will be disqualified and instead will be treated similar to any RMD or other distribution from the IRA. The maximum amount of QCD per tax payer is $100,000 o For a married couple, each spouse can make a QCD for $100,000 as long as the QCD comes from each spouses separate/individual IRA. Charitable recipient must be a public charity (think your local church or synagogue) and cannot be a Donor Advised Fund or Private Foundation, check with tax counsel to make sure the charity meets IRS requirements The check from the custodian MUST be made payable direct to the Charity. Strategy should be used for Individual IRAs; we have been advised that the QCD may not work for SEP or Simple Plans. The QCD must be the first distribution withdrawn from the IRA in the tax year, the first dollar withdrawn is assumed to go towards the RMD and there are no do overs. We have been advised that the QCD should be noted on Line 15(b) of tax return. Of course, confirm with tax counsel. The QCD may provide all sorts of benefits including a reduction of the tax burden on Social Security Benefits, potentially reduced cost for Medicare (lower taxable income from the QCD) and should reduce the overall tax bill. The owner of the tax deferred account that was already planning to donate to charity, can now implement what they were planning to do anyway, but be charitable in a more tax efficient manner via the QCD. With the tax savings, maybe the account owner can be a little more generous with the charity or reward themselves as well by using the savings from the QCD to fund a vacation for being so charitably inclined!! Michael Lynch, CFA, CFP Optimized Transitions

7 Please feel free to contact an Optimized Transitions Advisor to learn more about Financial Planning techniques including QCDs and our Investment Management process by calling at (800) or visit us at Disclosure The information provided in this document is for educational and/or general information and is not intended to provide specific legal, accounting, tax, estate planning or other professional advice. For specific advice on aspects of these topics, a client should consult with their professional advisors. The information provided is not an offer to buy or sell any security, option or strategy. This communication cannot be used by a tax payer to avoid US Tax penalties. Additionally, it is important to note that information in this report is based upon financial information input on the date above; results provided may vary over time and with subsequent uses and the opinions of the author may change at any time. The described strategies contained are not specific recommendations. The strategies described are not suitable for every investor, and require analysis by qualified professionals OPTION DISCLOSURE: Options involve risk and are not suitable for all investors. All clients engaging in an options transaction must receive an options disclosure document provided by Optimized Transitions or at www. otwealth.com.