I don’t know about you, however, whenever I’ve been required to do anything, I’ve never looked forward to it. This includes childhood chores like making my bed and mowing the lawn, taking prerequisite courses in college, and satisfying professional continuing education requirements.
It’s not enough that I’ve fulfilled, and continue to fulfill, numerous personal and professional demands. When I turn 70-1/2, I will be subject to yet another obligation that will be enforced for the rest of my life – Congress’ required minimum distribution rules.
Required Minimum Distribution Basics
Assuming that you have one or more retirement plans, you need to take required minimum distributions (RMDs) from your plans each year beginning no later than April 1st of the year following the year that you turn age 70-1/2. Retirement plans include all employer sponsored plans, including traditional and Roth 401(k) plans, profit-sharing plans, 403(b) plans and 457(b) plans. Traditional IRAs, SEP-IRAs, and SIMPLE IRAs, as well as inherited traditional and Roth IRA accounts, are also subject to the rules.
RMD amounts change each year. They may increase or decrease depending upon two variables: (a) the value of your retirement plan accounts on December 31st of the prior year, and (b) a life expectancy factor obtained from tables in IRS Publication 590-B. If you fail to withdraw your RMD by the applicable deadline, which is December 31st after the initial year, the amount that hasn’t been withdrawn is subject to an excise tax of 50%.
The main problem with RMDs is lack of predictability of projected annual withdrawal amounts compared to projected retirement income needs. RMDs are dependent upon retirement plan account values which, in addition to contributions, are dependent upon return.
Ignoring future contributions and potential withdrawals before age 70-1/2, let’s assume that you’re 50 years old, single, plan to retire at 67 when you will begin receiving Social Security benefits, and the value of your traditional IRA is $300,000. What will be the amount of your annual RMDs beginning at age 70-1/2? The answer to this question is that it depends upon the underlying investments in your IRA and annual rate of return.
Let’s assume that your traditional IRA appreciates 4% each year for the rest of your life. Per Exhibit 1, the value is projected to increase from $300,000 at age 50 to $684,000 at age 70. RMD’s are projected to increase from $26,000 beginning at age 71, to $35,000 at age 80, and to $44,000 at age 90 at which time they’re projected to level off and begin decreasing.
Since you’re planning for retirement and a long lifetime is a possibility, you want to receive a predictable and sustainable lifetime income stream to supplement Social Security while reducing investment risk. You discuss your goals and concerns with your retirement income planner. She recommends that you transfer your traditional IRA into a deferred income annuity (DIA) with a highly-rated life insurance company.
Assuming that you implement your advisor’s recommendation, you will receive monthly lifetime income of $4,059 beginning at age 70-1/2. There are additional guarantees built into your contract, including a return of premium, or investment, in the event that you die before age 70-1/2 and a 10-year certain payout if you die after your payments begin and before age 80-1/2.
Per Exhibit 2, you will receive income distributions totaling just under $49,000 a year from your DIA for the rest of your life beginning at age 70-1/2 in October, 2037. This amount is projected to initially exceed your annual RMD’s by $23,000, declining to an advantage of $13,000 at age 80 and $5,000 at age 89.
Fixed Income Annuities Exempt from RMDs
Fixed income annuities are exempt from RMDs since they have no cash value that can be used in a RMD calculation and the annuity payments are the same each year. Although they’re exempt from RMDs, payments from fixed income annuities held inside retirement plans must begin no later than age 70-1/2.
The income start date of qualified longevity annuity contracts (QLACs), a special kind of DIA designed for non-Roth retirement plan accounts, can be deferred to age 85. QLACs have a maximum allowable investment of 25% of the value of retirement accounts subject to a cap of $125,000.
RMDs vs. Fixed Income Annuity Payments
RMDs may not meet one’s needs since they’re calculated amounts based on fluctuating account values subject to underlying investment values and changing life expectancy factors. Annual calculations must be made and calculated amounts withdrawn by stipulated deadlines to avoid a 50% excise tax.
Fixed income annuity payments, on the other hand, are contractually fixed amounts that can be predetermined years before their start date to cover projected expenses beginning at age 70-1/2. Unlike RMDs, fixed income annuities aren’t subject to investment risk.
Fixed income annuity payments will often be greater than RMDs in early years. Annual differences will be dependent upon retirement plan annual investment returns. While investment accounts can be depleted, fixed income annuity payments will be paid for the remainder of one’s life. Best of all – they’re not required!