Saving and investing for retirement is tough enough, but it’s only one part of the retirement game, according to Ed Slott, author of The New Retirement Savings Time Bomb.
In fact, that part is just the “front nine” of the retirement game. The “back nine” is getting the money out of your retirement accounts in the most tax-efficient manner possible. And to do that, you need only follow five easy steps, Slott said in an interview.
Step 1: Time It Smartly
You’ll need to choose the right time to start taking your money out — and the right amount to take — to escape racking up huge tax bills, plus penalties, that stem from withdrawing too little, too early, or too late.
“Timing is everything,” Slott said.
According to Slott, there are basically three times you can take money out: Too early, The sweet spot, and Too late — or what he calls RMD time.
Too early is generally any time before age 59½. Money withdrawn from retirement accounts is generally subject to a 10% early withdrawal penalty. And you should avoid withdrawing money early if at all possible. “To me, it’s a deal-breaker to pay that early 10% penalty,” he said. “That’s money in the garbage.”
Of course, some have no choice but to withdraw funds from their retirement accounts before age 59½, said. And some can take advantage of some exceptions. “But hopefully you don’t need (to do) that because retirement money is for retirement,” Slott said. “And if you raid it early, what’s going to be left when you need it later?”
The sweet spot to withdraw money from your retirement accounts is between 59½ and 72, according to Slott. For one, there’s no 10% early withdrawal penalty. And two, you’re not required to take a distribution as you are after age 72.
“You can do whatever the heck you want,” said Slott. “It’s this little oasis in the middle of this giant tax code, where there are no rules.”
And this “sweet spot” may be a particularly good time for Roth IRA conversions, said Slott.
There are, of course, some withdrawals that could result in adverse consequences. For instance, you could find yourself paying more for Medicare Part B and Part D premiums if those withdrawals increase your modified adjusted gross income above certain amounts.
“But other than that, the big rules don’t apply,” said Slott.
Starting at age 72, retirement accounts owners have to start required minimum distributions or RMDS, said Slott. And that’s what he calls “the government plan.”
And you don’t want that plan. You want your plan, said Slott.
What’s the government plan? “It’s doing absolutely nothing,” he said. “And letting it happen to you. Because if you don’t have a plan, they have one for you beginning at 72, you’ll be forced to take your money out at the prevailing rate, whether you want to or not. And now you’re kind of out of control. You’re their plan.”
Now, this doesn’t mean you can’t do any planning after age 72, but you will have some constraints.
Step 2: SECURE It
The SECURE Act, which became the law of the land on Dec. 20, 2019, did many things.
- It repealed the age 70½ restriction for making contributions to traditional IRAs.
- It allows for penalty-free withdrawals from company plans and IRAs for births or adoptions.
- It raised the RMD age to 72 from 70½.
- And the law eliminated the stretch IRA for most non-spouse beneficiaries and replaced it with a much shorter 10-year rule.
In effect, it eliminated the so-called stretch IRA for many beneficiaries. Now (beginning with deaths in 2020), most of your non-spouse beneficiaries (your children or grandchildren, etc.) will have to withdraw and pay tax on the retirement funds they inherit from you by the end of that 10-year window, according to Slott.
And that means you’ll need new planning alternatives to avoid the tax hit your beneficiaries may take.
What to do?
First, do what most people don’t do: Set up a beneficiary plan, and second, you’ll need to know about the different kinds of beneficiaries and the payout periods that will affect each type of beneficiary.
“This is where some of the biggest mistakes are made,” he said. “Especially now after the SECURE Act upended estate planning for most people. It turned IRAs upside down. Many people don’t check these beneficiary forms.”
And the plan you’re laying out for your beneficiaries is on the beneficiary form of your retirement accounts. “It overrides the will,” said Slott.
In fact, one of the worst things you can do, this is one of those landmine mistakes, is not have a beneficiary named on your retirement accounts and having it pass through your estate, through probate where the assets might not even go to the intended beneficiaries, said Slott.
And life cycle events — births, deaths, divorce, marriages and remarriages — are the perfect time to review your beneficiary forms, said Slott.
Make sure, too, that you know where your beneficiary forms are. “This is your plan,” said Slott. “This is everything you worked for. And your family should know where these things are and know that it’s (been updated) to whatever your wishes are.”
Step 3: Roth It
According to Slott, the Roth IRA is the single best gift Congress has ever presented to the American taxpayer. “It allows us to build retirement accounts that, over the long haul, will grow to an incredible size — and remain free of income tax forever,” he wrote in his book. “There is only one catch: You have to pay the income tax upfront. Many people run screaming the other way when they hear that. But the big changes in the recent tax laws have made even paying the tax palatable for most. When it comes to retirement planning and account protection, keep your eye on the big picture.”
And Roth IRA conversions are among the things you might consider doing to avoid having some of your beneficiaries withdraw assets from an inherited IRA over 10 years. “It is not uncommon for people’s largest asset to be their IRA and 401(k), and imagine having all of those funds as your largest asset in one big bag of tax,” he said. “That’s not diversification.”
Step 4: Insure It
“The single best, most cost-effective yet amazingly underutilized strategy for protecting retirement account balances, especially large ones, from being decimated by the highest levels of combined taxation is to buy life insurance to offset the tax burden that beneficiaries may face,” Slott writes. “In other words, leverage your retirement savings, rather than letting the funds sit there waiting to be decimated by future taxes.”
And here’s what you need to do, according to Slott.
“Begin by working with your financial and tax advisers to draw down IRA funds. Sure, these distributions are taxable, but keep in mind that you’re paying taxes now as part of executing a more tax-efficient long-term estate plan. These funds will be used to build tax-free assets inside a permanent, cash-value life insurance policy (as opposed to term insurance, which expires at the end of the term and builds no cash value). To ensure the lowest possible tax cost, take smaller distributions over the course of several years. Spreading out distributions will allow you to take advantage of lower tax brackets. Then use the retirement funds you’ve withdrawn (that were earmarked for beneficiaries) to purchase a permanent life insurance policy. If a trust is needed for post-death control, the life insurance can be owned by a trust — an irrevocable life insurance trust (ILIT).”
And how much life insurance should you have?
“At a minimum,” Slott wrote, “you should have enough to cover the taxes and other expenses that must be paid on your estate after you’re gone. To do that you will need to know the balance in your account at the time of your death, which means you will have to project that balance.”
And the policy should be set up so that it pays off when funds are needed after death, according to Slott.
Step 5: Avoid the Death-Tax Trap
“The death tax is not a big deal for people, but it could be,” said Slott. “This is something that’s on the chopping block.”
And a part of the planning, he said, is not so much about the taxes. “It’s getting the funds that you’ve saved for such a long time out to those beneficiaries you named,” Slott said. “And if you use my plan here, the family can actually have larger inheritances, more control and less tax.”
So how might you create a perfect IRA/estate plan?
Well, from a federal estate-tax planning perspective only, most married couples can now name each other as their sole IRA beneficiary. With $20- plus million of combined estate-tax exclusion available, there is a much lower probability that the estate of your surviving spouse will owe federal estate tax, even with an inherited IRA, he wrote.
But before you do that. Look at all the variables. “In some cases, the simplicity of just naming your spouse as the direct beneficiary of your accounts may pay off, but in other cases, more elaborate estate planning will still be appropriate,” he wrote. “Remember, estate planning is more than just planning to avoid estate tax.”
Slott also noted in his book that the only reason to name a trust as the beneficiary of your IRA (or Roth IRA) is for personal (nontax) reasons, such as restricting access to the buildup by beneficiaries who might be too young (i.e., a minor child), mentally incompetent, or prone to squandering it on a hot Ferrari or a cool vacation.
Making it Last
“Anybody can have more, keep more and make it last,” he said. “That’s the bottom line. You worked hard for this money. You should have a plan to keep more of it because that’s when you’ll need it in retirement…. You can complain about taxes or do something about them. I’m giving you an opportunity here to do something about it.”