Retirement income
No retiree wants their nest egg to run out while they are alive. This fear can be overcome with a well-thought-out retirement income plan - one that you are confident will work for you. Optimizing your retirement income starts with knowing how much you can spend each year, which investment account to withdraw from first, when to begin taking social security, and making important choices between electing your pension as a lump sum or taking the monthly income.
To better understand how to optimize your situation, choose from one of our many blog posts about retirement income below:
Introduction to Withdrawal Planning During Retirement
Searching online about how to retire and use your savings to live on in retirement turns up tons of information. There are articles about the percentage to take out, the taxes to be aware of, and the rules and regulations. The type of article that you probably won’t find is the one that puts these academic facts together with a person’s life considerations to try and offer a real plan of action for withdrawals. This Retirement Income Series of blog topics will seek to do that.
Ground rules: This series is going to assume that you consider yourself financially ready for retirement, and any questions surrounding having enough money to retire have already been answered. It also is going to assume that you have already decided when to take Social Security, pensions, and any other regularly recurring income you may be eligible for in retirement. These resources don’t have to be started yet, but we’ll assume you know your age at which you will begin receiving them.
The first thing to realize is that deciding to enter retirement and use your life’s savings to live off for the rest of your days is a huge shift in perspective. In our company we joke with clients that it’s like you have an invisible switch on the back of your neck that you never knew about. It is called the “worry about money” switch. When you are on your final glide path into retirement, that switch gets flipped on because at some level of consciousness you start to realize that whatever amount you’ve saved up is likely to be all you will have for the rest of your life. When you cut your lifeline to the working world, you probably can’t go back…or at least you likely don’t want to.
Studies suggest that one of the biggest fears that many retirees have is running out of money before running out of life.1,2 Easy math would suggest spending conservatively is likely to fix this problem. But there’s another fact to consider - you can’t take the money with you. Whatever happens to us humans when we leave this planet, any wealth we leave behind is going to pass on to someone else for their use. Maybe that’s what you want; maybe it’s not! We work with many clients who tell us, in a perfect world, they would spend down their assets so that on their deathbed their last check bounces. How do you achieve that perfect timing if that’s your goal? We’re going to try and help you figure it out.
In this Retirement Income Series, we’ll discuss:
The 4-step planning process that’s key to ultimately determining the retirement income and withdrawal plan that fits you. These steps include:
Begin with the end in mind: what’s your ultimate nest egg goal?
Understanding different withdrawal methods that tell you how much money you can take out.
YOUR retirement building blocks and when and how to use them for maximum effect.
Tying these 4 steps together effectively is what most of the random financial articles about making portfolio withdrawals are missing. But the information needed doesn’t end there, so next we’ll overview:
Item 5: The mechanics of making those withdrawals. Think about it: most of the places where you hold your accounts don’t tell you how to take money OUT. For many retirees, when they retire is the first time they ever access these accounts other than making deposits. Knowing HOW to do it as easily as possible is helpful. Avoiding costly mistakes and frustrations is another key item.
Item 6: If you’re retiring before the age of 73 then most withdrawal choices are under your control. After that age, the IRS has their own plan for you to take money out, called Required Minimum Distributions (“RMDs”), or Minimum Required Distributions (“MRDs”). We’ll overview important basics and other more nuanced rules you may not be aware of but will want to know to optimize your withdrawal strategy.
Item 7: Finally, we’ll cover strategies and optimizations you can consider if you project extra money that will be left over at the end of your earthly journey. We’ll include techniques to consider if you want to do one or more of the following: leave legacy to heirs, gifting during your lifetime, charitable giving, or spending more on yourself.
So, stay tuned to our Retirement Income Series! Our goal is to help you optimize and maximize your wealth, to give you the retirement withdrawal insights you seek for living your life in retirement as you desire. The right approach is both a science and an art.
Footnotes:
1 US News & World Report, “Common Retirement Financial Fears and How to Overcome Them”, 11/18/2020.
2 Transamerica Center for Retirement Studies, “Retirees’ Greatest Fears – Infographic”, 2022
Step 1 of 4: Begin with the End in Mind - Your Nest Egg Goal
Welcome back to our Retirement Income Series! Are you looking to retire and figure out what the retirement nest egg you’ve been building for all those years can do for you? In this article we’ll dive into the first step in the 4-step planning process that’s key to a retiree determining their own retirement income and withdrawal plan.
The 4-step process looks like this:
Begin with the end in mind: what’s your ultimate nest egg goal?
Understand different withdrawal methods that tell you how much money you can take out.
Perform multi-year tax planning to minimize taxes in retirement.
Get to know YOUR retirement building blocks and when and how to use them for maximum effect.
So, this article centers around step one – “Begin with the end in mind: what’s your ultimate nest egg goal?”
This step might seem like it has an easy, basic answer: support an individual’s retirement needs and lifestyle. For retirement-minded individuals, that’s usually true. However, the real question is: are there any other goals wrapped into that? Some individuals will say no, and that everything they saved is intended for their own use. In fact, many go on to add that if they had a crystal ball and knew when their journey on earth was going to end, they’d spend down to their very last dime, maybe even bouncing their last check on their death bed. Other individuals feel quite differently, wanting to never spend down their nest egg. Sometimes this is for security-motivated reasons, knowing that if they never run out of money, they can always take care of themselves. Still others are preserving their nest egg for the benefit of other people, which might be family or friends, or even charitable organizations or causes they care about.
The spectrum of outcomes may look like this:
Studies suggest that outcomes at the end of life do have a range as shown in the bell curve above – with starting amount of retirement assets, length of life, and adverse life events playing a key role in outcomes.1 However, in large part an individual’s ongoing life choices on how they spent their money also played a role in whether they ended life with, or without, any nest egg left.
In my 20+ years of asking retiree clients about these wishes, the average person seems to fall somewhere in the middle. They note that their primary goal is to use their wealth for their own purposes, for enjoyment as well as to avoid being a burden on anyone else. However, if there’s anything left over, they want it to go to the people or organizations they care about. In many ways, this outcome is the easier one to plan for. There’s no specified end financial number, but rather a range of outcomes that would be acceptable. If this is your goal, then the key is to learn how much you can realistically spend along the way, and the type of monitoring you need to do so you can adjust if necessary. We’ll cover how to do these things in the next step of the 4-step process.
What if, instead, your goal lies at the far-right end of the spectrum, and you’d like to preserve as much of your nest egg as possible, potentially even sacrificing your own lifestyle to leave money behind? Individuals with a special needs child, an elderly family member, or others they care for who struggle to be self-sufficient often fall into this category. The nest egg of this individual will likely need to work harder because it needs to support two different goals and time horizons: the retiree, but also whoever needs the money next. In the next part of the 4-step process, step 2, we’ll discuss the withdrawal methods that best support these goals.
Finally, for those that saved their retirement assets for their own use and would prefer to reap the full benefit of it with intention throughout their lifetime and not leaving any money behind: this may be the hardest goal to achieve. Well, there’s a caveat: if you know when your death is going to occur, you could plan it easily. Unfortunately, most people are unable to predict when they are going to die . If they do know, it usually means that their time horizon is often quite short. AND when they do know, if they have larger sums of wealth, it might be hard to spend it all in meaningful ways before they pass on. How do you accomplish this goal? Do some very thorough planning. Address as many contingencies up front as possible, so that there’s a good likelihood that whatever is left is available to be used however you desire.
There are many contingencies that you may wish to consider. Some common ones include major health issues, the need for long term care as you age, needing to help a loved one financially which takes away from your own resources, the desire to create a fund for grandchildren’s college, and married individuals should plan for one spouse potentially passing away years before the other. There may be others; it’s a good idea to try and envision your own future life path and what realistically could go wrong, and how you’d want to be prepared for it financially.
In conclusion, with YOUR goal now firmly in mind, you will have the ability to more easily determine the withdrawal method that best fits your situation. That’s Step two in the process, which we’ll discuss it in our next blog post in this Retirement Income Series. Stay tuned!
Footnotes:
1 https://www.forbes.com/sites/howardgleckman/2018/04/18/many-americans-go-broke-in-retirement-but-many-others-gain-wealth-in-old-age/?sh=4f250161697d by Howard Gleckman, which cites 2 studies: 1) by Sudipto Banerjee of the Employee Benefit Research Institute, and 2) by James Poterba, Steven Venti, and David A. Wise of the National Bureau of Economic Research.
Step 2 of 4: Understanding Different Withdrawals Methods
This article is entry #3 in our Retirement Income Series and is Step 2 of a 4-Step planning process that we employ. As a refresher, that 4-Step process includes these steps:
Begin with the end in mind: what's your ultimate nest egg goal?
Understand different withdrawal methods that tell you how much money you can take out.
Perform multi-year tax planning to minimize taxes in retirement.
Get to know YOUR retirement building blocks and when and how to use them for maximum effect.
Hopefully, you've taken some time to review the article on Step 1 and now have a sense of your own goals for your nest egg. Whenever you are “beginning with the end goal in mind,” the objective is to determine whether your retirement assets are intended for: 1) only you and your retirement, so you intend to spend it all during your lifetime – we call this the SPEND DOWN GOAL; 2) your retirement but with some money left over for other goals or because you'd prefer to have a cushion – known as the SAFE SPEND GOAL; or 3) you, while also prioritizing leaving behind a sizable legacy to whoever comes after you, whereby those assets can financially support that person – the LEGACY MAX GOAL.
With your nest egg goal clearly defined, you are ready to move on to Step 2: figuring out how much money to take out and deciding what method is best suited. To determine which method is appropriate, we first need to know what methods are available. As it turns out, there are three methods that we will be covering among a number of withdrawal strategies that are available: 1) Budget Shortfall, 2) Portfolio Income and Gains, and 3) "Safe" Withdrawal Rate. Let's take a closer look at each of these methods so that you can understand how to apply them to your overall retirement income goal.
Budget Shortfall
The simple way to start with this strategy is to take your monthly expenses and subtract your monthly fixed income (e.g., social security and pensions) to determine your monthly withdrawal amount. Put another way, this is your income shortfall and represents the amount that needs to be taken out of your nest egg. If there is enough in the nest egg accounts for whatever amount of time you hope to live in retirement, then everything works out as intended, and you've accomplished your goal.
However, the challenge with this method is that there are no guardrails on what a safe level of spending might be before you run out of money, which is why we commonly align this withdrawal strategy with a SPEND-DOWN GOAL. Be mindful that when the portfolio's growth can no longer sustain the withdrawals being taken out, you may need to reduce your overall spending later in life to keep your nest egg afloat. On the other hand, if you have accumulated a lot of assets and your goal is to bounce your last check, you might not be spending enough and could have lived a more extravagant lifestyle than you did.
Portfolio Income and Gains
The Portfolio Income and Gains withdrawal strategy provides income from the dividends, interest, and gains generated from the total balance of your retirement accounts, allowing you to keep the principal intact and MAXIMIZE YOUR LEGACY. If leaving a certain level of inheritance behind for your loved ones is important, this retirement income strategy will be most effective.
The issue for some is that to produce a meaningful enough income to support your lifestyle, you must set aside a significant nest egg, which means that for the average retiree, this method is best used for discretionary spending. These are things you want but don't need – travel or home upgrades serve as a couple of examples.
The other challenge is that the income amount will vary year-to-year because growth in the stock market is unpredictable, and bond and cash interest rates change over time. The bottom line is that there are some years you might not see any growth; therefore, you may end up not taking any income that year, unless you are willing to spend down your principal.
"Safe" Withdrawal Rate
If you are someone who looks at the Budget Shortfall method and says, "I don't like the idea that I might run out of money, or I don't want to find myself in a position where I will have to cut back on my lifestyle at some point substantially," then the "Safe" Withdrawal Rate income strategy may be more suitable to meet your needs. We label this the SAFE SPEND GOAL. In other words, this method effectively addresses your fear of running out of money before running out of life. It's also the middle ground between the other two methods because it also allows you to pass on some of your assets to the next generation, albeit to a lesser degree than the Portfolio Income and Gains method.
Research studies suggest that as a rule of thumb, 4% of your nest egg account value is considered the "safe" annual withdrawal rate a retiree can rely upon and not worry about running out of money. For example, if you have a $1M nest egg, your "safe" withdrawal amount for the year would be $40,000. Keep in mind that your withdrawal amount must be adjusted each year according to the account value. Therefore, your income will fluctuate up and down with your portfolio value. However, the hope is that through enough portfolio growth, you will receive pay raises over time that will keep pace with inflation.
Where some retirees might take issue with this strategy is that there are many exceptions to rules of thumb. For some, a safe withdrawal rate is 2% -3%. For others, it could be as high as 5%. Much of what is considered safe will depend on the growth of your portfolio (the stock market and interest rates), inflation, and longevity. If your portfolio is positioned for preservation and less growth, and you expect to live to 100, your safe withdrawal rate will likely be closer to 3% or less. Conversely, if your portfolio is positioned for growth in a low-inflation environment, it's possible to withdraw as much as 5%, and it be considered safe.
Connecting the Dots with STEP 1 and STEP 2
To conclude our discussion, it's critical to understand how Steps 1 and Step 2 of the retirement income planning process work together. To that end, PARAGON has created the table below to summarize the three nest egg goal types, the corresponding strategy to consider, and the pros and cons to evaluate for that strategy.
Step 3 of 4: Perform Multi-Year Tax Planning to Minimize Taxes in Retirement
This article is entry #4 in our Retirement Income Series and is Step 3 of a 4-step withdrawal planning process that we employ – performing multi-year tax planning to minimize taxes in retirement. To recap, the 4-steps to YOUR retirement income plan are:
Begin with the end in mind: what's your ultimate nest egg goal?
Understand different withdrawal methods that tell you how much money you can take out.
Perform multi-year tax planning to minimize taxes in retirement.
Get to know YOUR retirement building blocks and when and how to use them for maximum effect.
Before you learn more about Step 3, we recommend reading Step 1 and Step 2 if you haven't already.
To effectively perform multi-year tax planning strategies, you need to start by looking at your overall income picture over your lifetime. Every single year is accounted for. Doing it this way creates a timeline that allows you to evaluate the bigger picture and identify where specific planning strategies along that timeline may help reduce your overall tax burden. Through this process, the goal is to determine which accounts to withdraw from and when based on your income and expense situation during various segments of time.
Taking it a step further, some of the main components that affect how your retirement income will project over time are:
The timing of when you take social security and pension income.
The timing of when you begin taking distributions from taxable accounts versus tax-free accounts.
The timing of when the IRS requires you to take distributions from pre-tax accounts.
WITHDRAWAL PLANNING TIMELINE
To help visualize how the retirement timeline is mapped out, the following examples below illustrate two common scenarios:
To understand the big picture, let's dive into what's happening in both projections in the above graphs. We will assign names to each chart so that it's easier to follow along. The graph to the left is for Joe Sample, and the diagram to the right is for Bob and Cindy Jones.
Starting with the graph to the left, we see that Joe Sample receives a steady income throughout his retirement. At the same time, Joe's expenses remain elevated above his income for the entirety as well. This gap in spending and income means that Joe will need a modest level of portfolio withdrawals each year to supplement his lifestyle.
The second graph to the right shows that Bob and Cindy Jones' fixed income is much lower during the first few years of retirement because they delayed receiving their social security income and didn't need to pull income from their pre-tax IRAs. Also, during this brief period, expenses are higher than income, so Bob and Cindy must use their bank account savings and other tax-efficient investments to cover their shortfall. Notice that once their social security and required minimum distributions (RMDs) kick in, their income remains higher than their living expenses for the rest of their lives.
Unfortunately for Bob and Cindy, their taxes will increasingly become more expensive as they grow older. Instead, they would benefit by mapping out a timeline of cash flows. In doing so, they would recognize that withdrawing from pre-tax accounts sooner would spread their tax liability over their lifetime, reducing their lifetime tax liability.
TAX STRATEGIES FOR RETIREMENT
Now that you understand how to plot out your plan, let's examine six specific tax planning strategies that can help you minimize your tax liability during retirement.
1) Delaying Social Security Benefits
When you retire in your early-to-mid 60s, you have a decision to make about social security and when to take it. Delaying your social security benefits until your full retirement age (or as late as age 70) creates a window of time when you will need to live on other assets to get by. In such instances, consider drawing from tax-favored accounts like Roth IRAs and taxable investments to keep your taxable income lower for that stretch of time.
Qualified distributions from your Roth IRA are tax-free, so if you have enough Roth money, you can enjoy your go-go years of retirement without paying any taxes. If leaving a significant legacy isn't important, you may consider such a withdrawal strategy, as there are other potential financial benefits, like reducing your ACA health insurance premiums until you are eligible for Medicare.
Also, suppose you have a taxable account, such as a brokerage or high-yield savings account. In that case, you can rely upon those assets to generate interest, dividends, and capital gains income. The benefit of living on long-term capital gains and qualified dividends is that they are taxed at a preferential rate of 15% for most retirees. In some cases, the taxable rate on capital gains income can be 0% or 20%, depending on how your income is structured that year.
2) Managing Investment Income
Another way to reduce the taxable income generated from your after-tax investment accounts is by shifting some of those dollars into municipal bonds and annuities. The interest generated from municipal bonds is generally federally tax-exempt for fixed-income investors. They are also usually exempt from state income taxes if the bond issuer is in the investor's home state. These types of bonds are especially attractive to retirees in a high tax bracket.
Annuities are another vehicle that allows retirees to tax-defer the growth of their after-tax savings (non-qualified money). In other words, when capital gains, dividends, and interest are earned within the annuity account, no taxes are due until the annuitant receives income. Also, because most annuities don’t force income distributions until age 90, the owner has the option of deferring taxes for a majority of their lifetime. The earnings come out first and are taxed as ordinary income upon distribution. After all earnings are exhausted, the principal is withdrawn without incurring taxes since that money was already taxed.
3) Tax-Advantaged Retirement Accounts
If you fall into the semi-retired category, you may be earning consulting income as a 1099 contractor. In this case, consider deferring part of your earnings into retirement accounts such as a solo 401(k), SEP IRA, SIMPLE IRA, pension, or cash balance plan. Understanding which type of retirement plan is applicable to meet your needs is beyond the scope of this article; however, the benefit of putting money away into a pre-tax retirement plan is that you reduce your taxable income. For example, defined contribution plans such as a solo 401(k) allow you to tax-defer as much as $66,000/year ($73,500/year if older than 50).
4) Roth Conversions
For a more in-depth understanding of Roth conversions, we have an entire library of articles found here – Roth Strategies. The basic premise of a Roth conversion strategy is that by shifting dollars from your traditional pre-tax IRA to your tax-free Roth IRA, you are paying taxes now with the expectation that you (or your heirs) will benefit from saving money on paying taxes over the long term
Therefore, the ideal timeframe to consider Roth conversions is when your income is lower relative to other segments mapped out along your retirement timeline. In addition, it makes sense to evaluate Roth conversions when you have a sizable traditional IRA subject to significant RMDs. More on that is detailed below in point #5.
5) Planning for Required Minimum Distributions (RMDs)
Suppose you are a retiree who only needs the income from your IRA once the IRS says that distributions are required. In that case, you might be setting yourself up for disappointment when you turn 73 - the age at which the IRS currently requires mandatory distributions. Say you have $3M saved in a traditional IRA; your RMD when you turn 73 would be $113,207. Add that to your social security income and income generated from investments, and it's possible you suddenly jumped into a higher tax bracket. A way to plan around this is to smooth out your distributions from your traditional IRA leading up to RMDs or perform Roth conversions several years before you turn 73. To learn more about RMDs, we cover this subject in more detail in the following article – Managing your Required Minimum Distributions (RMDs) in Retirement.
6) Tax Deductions
With the standard deduction set at $27,700 (+1,500 for each spouse above 65) in 2023, itemizing your deductions has become a challenge for the average retiree. Especially if your house is paid off and you no longer get the mortgage interest deduction. However, an effective way to occasionally increase your deductions above the standard deduction is bunching your itemized deductions. The simplest way to think about this strategy is to effectively pay two years' worth of deductions in a single tax year so that you can hurdle over the standard deduction. Then the following year, when your itemized deductions are lower, you use the standard deduction.
PERFORMING MULTI-YEAR TAX PLANNING
In order to minimize lifetime taxes, you must understand the tax strategies available to you and how they can be incorporated into your cash flows from one year to the next. In other words, coordinating your withdrawal planning is an ongoing process that requires a lifetime projection of your retirement so that you can adequately identify which accounts to make withdrawals from and when.
From there, revisit your plan annually to:
Account for life changes.
Update your account values due to market forces.
Adjust for other tax changes.
Otherwise, you're likely paying too much in taxes.
Next, we will cover Step 4 of the 4-step Planning Process to YOUR Retirement Income Plan, where you will get to know your retirement building blocks and when and how to use them for maximum effect.
Step 4 of 4: Get to Know Your Retirement Building Blocks
This article is entry #5 in our Retirement Income Series and is step #4 of a 4-step planning process that we employ, called “Getting to Know YOUR Retirement Building Blocks and When and How to Use Them for Maximum Effect." As a refresher, our 4-step process to your Retirement Income Plan is as follows:
Begin with the end in mind: what's your ultimate nest egg goal?
Understand different withdrawal methods that tell you how much money you can take out.
Perform multi-year tax planning to minimize taxes in retirement.
Get to know YOUR retirement building blocks and when and how to use them for maximum effect.
If you still need to do so, we recommend reading our other Retirement Income Series articles that go over Step 1, Step 2, and Step 3. Briefly – as you define your goals, consider your withdrawal strategies, and evaluate how to minimize your taxes, you are ready to start using your building blocks. Each of these steps is an essential layer of the overall foundation. Once your foundation is built, you can confidently follow a retirement withdrawal plan that meets your goals and allows you to maximize the wealth you worked hard to save.
MEET YOUR BUILDING BLOCKS
Your building blocks are made up of pre-tax accounts, tax-free accounts that are funded with after-tax dollars, and after-tax accounts. Put another way, these building blocks are commonly known as:
401(k) plans, 403(b) plans, 457 plans, and traditional IRAs are your pre-tax accounts.
Roth IRAs and Roth 401(k) plans are your tax-free accounts that are funded with after-tax dollars.
Savings and brokerage accounts are your after-tax accounts.
Before diving into more specifics, you need a better understanding of how each building block is constructed. The figure below overviews how each account operates – everything from how a withdrawal is taxed, to the age you can start accessing funds, to the age the IRS says you are now forced to withdraw money, and last but not least, to the financial penalties that are applicable if you don't follow the rules.
When we analyze the table above, there are some areas to draw your attention to that are more nuanced and therefore need to be expanded upon. Let's start from the top down.
THE AGE YOU CAN BEGIN ACCESSING YOUR RETIREMENT FUNDS & TAXES
To incentivize retirement savings, the IRS provides tax breaks to those that save a portion of their paycheck into company sponsored retirement accounts or individual retirement accounts. The tradeoff for those tax incentives is the IRS restricts access to those same savings. In other words, 59 ½ is when the IRS permits withdraws from tax-favored accounts like traditional 401(k) plans and Roth IRAs.
If you follow their rules, you only pay income taxes for taking a withdrawal from traditional 401(k) plans, IRAs, and other pre-tax retirement vehicles (457, SEP, SIMPLE). What makes Roth accounts so popular is that they allow for withdrawals to come out tax-free – assuming certain requirements are met (more on that later). Whereas with brokerage accounts the realized profits (when you sell an investment security at a gain) are taxed at long-term capital gains rates of 15%-20%, if the investment was owned for more than a year. If owned for less than one year, then the gains are considered short-term and taxed as ordinary income. Similarly interest from savings and bonds are taxed as ordinary income.
Unfortunately, if you decide to break the rules and take a withdrawal before 59 ½, the IRS penalizes the taxable amount distributed at a rate of 10%. For example, if you are 52 and took out $100,000 from your Roth IRA, but only $30,000 of that withdrawal was taxable, then the IRS penalty applied to your withdrawal is $3,000 ($30,000 x 10%). If that same $100,000 came out of a traditional IRA, the penalty is $10,000 ($100,000 x 10%).
Aside from the penalty free withdrawal options discussed later in this article, a notable exception to the age 59 ½ restriction is that certain company-sponsored retirement plans allow for withdrawals starting at age 55. More specifically, when a retiree terminates employment with their most recent employer, that 401(k) plan may allow the former employee to take penalty-free withdrawals when they are 55 or older.
However, this rule does not apply to 401(k) plans that are tied to your previous jobs. In other words, you can only make penalty-free withdrawals from the 401(k) plan that you were most recently contributing to at the time you were terminated or retired. Let's review an example to help bring this point home - Bob Jones is the 401(k) owner and is 56. Say Bob worked for Florida Blue 20 years ago, but his most recent employer is Johnson and Johnson. Upon retiring, only Bob’s JNJ 401(k) plan is eligible for penalty-free withdrawals.
Another exception involves Roth IRAs. There are two components to the Roth IRA exception that you need to be mindful of, which are: 1) your original contributions can be withdrawn without incurring taxes or penalties at any time; 2) the 5-year waiting rule stipulates that you must wait at least five years after you first contributed to a Roth IRA account before you can withdraw the earnings tax-free. The reason your contributions are not taxed or penalized is because you already paid taxes on that money before it went into the Roth account.
MANDATORY WITHDRAWALS
Wait a minute... what the bleep? Does the IRS actually require you to take withdrawals from your retirement funds? Even when you don't need the money! The short answer is YES. That is for pre-tax accounts only. Roth IRAs are not currently subject to required minimum distributions (RMDs), and brokerages accounts are never subject to such requirements because those accounts do not receive the same preferential tax treatment as IRAs.
The current age at which RMDs kick in is 73; however, starting in 2033, the RMD age will be increased to 75. To complicate matters further, thanks to the passage of the SECURE Acts 1.0 and 2.0, the previous RMD ages were 70 ½ and 72 before the rollout of each respective law change.
Because the IRS likes to overcomplicate our lives and help people like me keep a job, I created the following table that organizes the year you were born to when your RMD age begins:
Due to the various nuances of RMDs, we will only cover the abovementioned fundamentals. To learn more in-depth details about RMDs, check out our other Retirement Income Series article – Managing your Required Minimum Distributions (RMDs) in Retirement.
PENALTY FOR SKIPPING YOUR MANDATORY DISTRIBUTIONS
What happens if you have not paid attention so far or you just flat out forgot to take your RMD one year? Well, consider yourself "lucky" because the penalty for skipping your RMD has decreased from 50% to 25%. Thanks again, SECURE Act! Sarcasm aside, this is something you will want to avoid. Even 25% is a steep price to pay for a simple mistake.
PENALTY-FREE WITHDRAWAL OPTIONS
As discussed earlier, withdrawing Roth contributions and the age 55 rule for 401(k) and 403(b) plans are exceptions to the IRS penalty. Unfortunately, some of the other penalty-free exceptions fall under the bad news is good news category. In other words, if you want to withdraw from your IRA or 401(k) without the IRS clipping off 10%, you can do so when a death, disability, or divorce occurs. Note that under the divorce scenario, a QDRO document is required for 401(k) and 403(b) plans (ERISA plans only).
Other exceptions include:
Both IRAs and 401(k) Plans
Un-reimbursed medical expenses in excess of 10% of your Adjusted Gross Income (AGI)
QBOAD – Qualified Birth or Adoption expense ($5,000 single, $10,000 married filing jointly)
IRAs Only
First-time home purchases allow the buyer to withdraw up to $10,000
College expenses
Health insurance premiums while unemployed
Lastly, a more complex withdrawal exception is the 72(t). This rule stipulates that you are permitted to make penalty-free withdrawals from an IRA or 401(k) as long as you take at least five substantially equal payments. Expanding on this further, you must withdraw your calculated amount for five years or until age 59 1/2, whichever comes later.
The dollar amount of your payments depends on your life expectancy and is calculated using one of the three IRS methods. Those three methods are 1) the required minimum distribution method, 2) the fixed amortization method, and 3) the fixed annuitization method. To learn more about each method in greater detail, read pages 2 and 3 of IRC Section 72(t). The bottom line is that 72(t) withdrawals are typically a last resort option.
SETTING UP YOUR RETIREMENT INCOME PLAN FOR SUCCESS
Armed with our 4-Step Process to YOUR Retirement Income Plan, you are ready to take it to the next level. Coming up next, we will go over the Mechanics of Making Withdrawals. Wouldn’t it be nice to just hit the EASY BUTTON and make it all magically work? Even though taking a withdrawal from your retirement accounts sounds simple enough, the truth is that there is more to it than meets the eye. With that in mind, our next article will teach you how to streamline accessing your nest egg and what pitfalls to watch out for.
Mechanics of making withdrawals
Mechanics of Making Withdrawals is entry #6 in our Retirement Income Series. This article will focus on how to get money out of your nest egg. In addition, we will provide you with the knowledge you need to properly plan, organize, and structure your withdrawals so that you have an easy process to follow.
We will begin by overviewing the three main account structures that you can make withdrawals from, which are IRAs, after-tax brokerage accounts, and employer plans (401(k), 403(b), TSP, 457). Next, we will examine your distribution options when leaving an employer and whether you should rollover your funds to an IRA or leave the money with your employer. After that, we will go over your options when you reach 59 ½ and are still working. Finally, we will provide the steps you need to take when moving your employer plan to an IRA so that you don’t cost yourself thousands of dollars.
First, let’s take a close-up view of what it looks like to take a withdrawal from each of the three types of accounts mentioned above.
IRAs
Individual retirement accounts (IRAs) offer the most ease and convenience of the three account types because of their flexibility, ability to pay taxes to the IRS at the time of distribution and make the deposit feel like you are getting a paycheck.
With IRAs, you can take money out on a one-time basis, or you can take it as a recurring amount on a monthly, quarterly, or annual basis. In other words, you have the flexibility to take both ad hoc withdrawals and automate your withdrawals.
One of the most convenient parts is having income taxes withheld from your withdrawals as a fixed dollar amount or specified percentage. Your withheld taxes are sent directly to the IRS at the time of withdrawal, similar to how your taxes are withheld from a paycheck.
In that same vein, you can establish an electronic funds transfer (EFT) between your investment account and bank account for direct deposits. For those uncomfortable with the EFT option, you may also receive a check in the mail.
After-tax Brokerage
Withdrawals from an after-tax brokerage account are nearly identical to IRAs in terms of how they operate. The only difference is that you cannot withhold taxes when a withdrawal is processed. Instead, you need to go to the IRS’ website at www.irs.gov and make a one-time payment for the estimated taxes you owe related to the capital gains generated. You might also consider mapping out what your annual dividends and interest payments will be so that you pay the taxes generated from those income sources in advance.
Employer Plans
Processing withdrawals from 401(k), 403(b), TSP, and 457 plans differ from the first two options we covered. Unfortunately, taking money out of employer plans is more cumbersome, as some employer plans may require signing a paper form to process a partial withdrawal. Even if you can process the withdrawal online, you must manually enter your request each time you want money. Meaning you are unable to automate your withdrawals.
When partial withdrawals are permitted, the employer plan typically requires a minimum of 20% for federal income taxes to be withheld. On top of that, your employer may restrict your withdrawal frequency, limit the amount you can take out, or require the entire account to be liquidated in order to access your money. Another potential nuisance is certain plans charge you a fee to process your withdrawal
You might ask yourself, “Why do employer plans make accessing MY MONEY such a hassle?” The simple answer is that your employer doesn’t want to act as your bank ATM because it is too costly and time-consuming for them to administer. It’s almost as if they encourage you to move your money elsewhere, which is why the most common solution to this problem is performing a direct rollover of your employer plan to an IRA. The nice thing about this type of transfer is that you don’t pay taxes if you execute each step of the rollover process properly.
We will cover more specifics about rollovers in a moment. Before we do that, let’s consider the different distribution options available when you leave your employer.
Distribution Options When You Leave an Employer
Upon retiring or terminating your employment, you have five options to consider with your retirement plan:
1) Take a Lump-Sum Distribution
A lump-sum distribution is the least desirable option, especially if your retirement plan has a significant balance. The result of a lump-sum distribution is that the amount received is fully taxable, and it may be subject to a 10% IRS penalty if you are under 55.
In other words, if you have $1M in your 401(k) plan, and you decide you are going to take a distribution because you don’t like investing in the market and want to buy your dream home on the beach, that is also going to be an income generating property via Airbnb – the unfortunate reality is that you only net $800k. So, instead of buying that $1M home with cash, you will need to find more financing or a less dreamy home. The more significant issue is that your $1M distribution is included in your taxable income – under current marginal tax rates, you’re now in the highest tax bracket at 37%. This means you may owe even more in taxes than the $200k that was withheld when you made your withdrawal and will have to settle up with the IRS at tax time.
2) Leave the Funds with Your Former Employer Plan
If the plan allows you to, you may leave your retirement with your former employer. It’s common to keep your money with your former employer if you are comfortable with the plan. Sometimes the path of least resistance makes life easier. However, if you have multiple retirement plans scattered around, managing your retirement could grow increasingly more difficult as you approach the age you are required to take minimum distributions (RMDs). Aside from the RMD issue, there are additional considerations we will get into in a bit.
3) Transfer Your Nest Egg into a New Employer Plan
If the thought of having multiple retirement plans scattered around sounds like a pain, and you prefer to consolidate the money with your new employer, then transferring your old plan to your new employer plan is an option you may want to do. Unfortunately, the problem with this approach is that the funds you rolled over may become less liquid if the plan has restrictions that limit accessing your money while you are employed.
4) Rollover Your Retirement Plan to a Traditional IRA
Another way to consolidate your retirement plans is by rolling over your funds to a traditional IRA. The benefit of doing so is that you have all your pre-tax retirement money housed in one spot, and you maintain a higher degree of liquidity. Additionally, your funds remain tax-sheltered while you leave the money in the IRA.
5) Rollover Your Retirement Plan to a Roth IRA
If you have a Roth retirement plan through your employer, transferring your funds to a Roth IRA is a non-taxable event. However, if the source of funds is from a traditional retirement plan, then the amount rolled into a Roth IRA is fully taxable. However, because the amount moved to the Roth is considered a Roth conversion, those funds are not subject to the 10% IRS penalty.
Should You Leave Your Money in Your Employer Plan or Roll It Over to an IRA?
When we eliminate lump-sum withdrawals from our consideration because of the tax implications, your distribution options can ultimately be boiled down into two big-picture choices – employer plans and IRAs. Deciding which account type is better for you will depend on your situation and goals and how well the other features available to you with each account meet your objectives.
The table below provides a side-by-side comparison of the benefits and drawbacks of choosing an Employer Plan versus a Traditional IRA. Note that the points listed in RED are the disadvantages compared to the other account alternative, and the text listed in BLUE are the positive features compared to the other account type.
Options for Employees Over 59 ½ But Still Working
After reviewing the pros and cons of rolling over an IRA, you might wonder what you can do if you are still working but want to rollover your employer plan to an IRA because you deem it the better option. As long as you are over the age of 59 ½, most employer plans will allow what’s called an in-service rollover to an IRA. An in-service rollover is a tax-free transfer of your assets from the employer plan to your personal IRA while continuing to allow you to contribute to your employer plan and preserve your company match.
To determine if your employer retirement plan allows in-service rollovers, you must review the plan rules, which are outlined in the Summary Plan Description (SPD) – this document can usually be found within the menu of options listed within your online portal. Sometimes you may need to contact your Human Resources department if it’s not readily available in a digital format.
When Moving Your Employer Plan to an IRA
When transitioning your nest egg dollars from an employer plan to an IRA, handling this type of transfer with care is critical because the financial consequences of messing it up can feel like a swift kick in the pants. With that said, there are two methods you should avoid: 1) taking an outright distribution and 2) indirect rollovers. On the other hand, the two options that you should consider utilizing are: 1) direct rollovers and 2) direct transfers. First, we’ll review what can go wrong, and then we will cover the right way to move your retirement funds to an IRA.
Distributions
The result of taking an outright distribution is that your retirement plan must withhold at least 20% for Federal taxes (some states might require withholding state income taxes as well). Under most circumstances, taking a lump sum should be a last-resort withdrawal strategy when desperate times call for desperate measures. Or consider taking the lump sum when you have an insignificant balance, and the tax impact is unsubstantial.
Indirect Rollovers
Moving your employer retirement funds via an indirect rollover is generally a no-no because the same issue with paying Federal income taxes can arise. An indirect rollover occurs when you get a check made payable to YOU, you CASH in that check, deposit it at your bank and then put all those funds BACK INTO YOUR IRA. Everything works out great if you complete the rollover within 60 days – no taxes. However, if you redeposit your retirement funds into your IRA on day 61, Uncle Sam will stick his hand out and collect. So, if the 60-day deadline cannot be CONFIDENTLY met, you should avoid this method of transfer. Keep in mind that the employer plan likely withheld 20% for mandatory tax withholding, so in order to fully rollover your account and avoid tax consequences, you’ll have to come up with that 20% in cash to supplement the check you received. Everything will even out when you do your taxes, but until then the IRS will hold on to that mandatory 20% that was withheld.
Direct Rollover
It’s funny how one word can make a huge difference – direct instead of indirect. A direct rollover means that the employer plan writes a check made out to your IRA custodian for the benefit of you, the owner of the IRA. The check is mailed to you or the custodian (e.g., Fidelity, Charles Schwab). In situations when the check is mailed to your home address, it is best practice to send those funds via FedEx or UPS to your custodian so that you don’t risk the check getting lost or stolen. The estimated $25 shipping fee is worth protecting the nest egg you worked so hard to build for all those years.
Direct Transfer
A direct transfer is the best option for moving your retirement plan to an IRA whenever it is available because the funds are wired directly from your plan to the IRA. The service rep on the phone takes down your account number and custodian information and mashes a couple of buttons... and voila, your money magically appears in your IRA within a few business days. You will still receive confirmation of the transfer via email or mail, but it’s also good to ask for a confirmation number before you disconnect. Ultimately, choosing this path prevents having to follow multiple steps, which is a common issue with the other options.
Managing your Required Minimum Distributions (RMDs) in Retirement
This article aims to provide the framework needed to understand how to take control of your RMDs throughout your retirement by teaching you what they are and how to calculate them. To tie everything together, we will illustrate why anticipating your RMDs can help you avoid the costliest mistakes, and then we will demonstrate how you can optimize your taxes with a little-known technique.
Understanding RMDs
A Required Minimum Distribution (RMD) is the minimum amount of money that a retirement plan account owner (401(k) or 403(b) plan) or traditional IRA owner must withdraw annually starting in the year they reach 73. Of note, this age requirement has become more generous, as it used to be 70 ½ as recently as 2020. What’s more, is that this age requirement will go to 75 starting in 2033.
The reason why mandatory distributions exist is the tax code set forth by Congress has allowed you to avoid paying taxes on that sum of money for an extended period; therefore, this is the government’s method of no longer subsidizing your ability to tax defer your nest egg. Instead, you must take out what starts as a small percentage of your account balance each year, and gradually that requirement grows into a larger percentage during your advanced years.
Important RMD Rules
The best way to stay current with the IRS’ minimum withdrawal guidelines is by referring to their life expectancy tables published in IRS Publication 590. Now that the “fun” IRS guidelines are out of the way… there is an exception to the age 73 minimum distribution requirement, which can occur when the retirement plan account owner is still employed and owns a 401(k) or 403(b) with that organization. Under such circumstances, that person may defer their RMD until the year they retire. Retirement plan participants should check with their employers to determine whether they qualify for this deferral.
Another important nuance to note is that the timing of your first RMD can be delayed a calendar year. That is because account holders are permitted to withdraw from their retirement account by April 1st of the following year when they reach age 73. However, if the account owner chooses to delay their first RMD to April 1st, they must take two RMDs during that calendar year.
For those of you who own Roth IRAs, those accounts are not subject to RMDs. This particular rule is why Roth conversions are a popular strategy, especially during years when your income might be lower than usual. However, Roth 401(k) and Roth 403(b) plans DO require annual minimum withdrawals. If you don’t want to be subject to such requirements, it will behoove you to rollover those funds to a Roth IRA.
Unfortunately, employer-sponsored retirement accounts are not included when allowing the aggregation of mandatory distributions, and each RMD must come out separately. On the other hand, IRAs are permitted to be combined for the purpose of taking the entire RMD amount from one IRA. For example, if you owned 3 IRAs totaling $1M and your RMD is $38,000, the entire $38,000 doesn’t have to be spread out proportionately across all three IRAs and can be taken from just one account.
The other issue with 401(k) plans is if you have multiple accounts scattered, it can be painful to manage as your mental capacity diminishes. One way to get ahead of this problem is to streamline everything by rolling over those accounts to an IRA. Otherwise, consider consolidating your other retirement plans to your current employer 401(k) plan (be sure to check if your employer plan allows rollover contributions).
How to Calculate
To begin, you will need to gather your ending account balance from the prior year. From there, refer to the IRS Uniform Lifetime Table III and use the corresponding life expectancy factor with your age in that calendar year. Using those two figures, you divide the prior year’s account balance by the IRS life expectancy factor to arrive at your RMD amount for the year. In other words, the equation is AB / AD = RMD, where:
AB = account balance at the end of the preceding calendar year
AD = applicable divisor (from Appendix C, Publication 590)
RMD = Required minimum distribution for the current year
Let’s look at an example to understand better how an RMD is calculated:
Bob Jones turns 74 in the year 2023, and his IRA had a year-end balance of $800,000. When we reference the chart below, we see that the applicable divisor is 25.5. Therefore, Bob’s RMD is $31,372.55 – calculated by taking $800,000 / 25.5.
When it is Important to Anticipate RMDs
A common misconception is that IRA custodians (e.g., Fidelity, Vanguard) and plan sponsors automatically process your RMD when, in fact, the onus is on the account holder to initiate the required minimum distribution. This ongoing responsibility to take RMDs on an annual basis is imperative to stay on top of because you will incur a tax penalty of 25% if you miss taking it. The IRS penalty is calculated by taking the difference between the required and actual withdrawals, in addition to the income tax that is due.
Anticipating your RMDs is critical to consider as part of your overall retirement income plan and how that plays into paying income taxes. Planning is especially vital when you have a large amount of IRA dollars saved. Retirees with higher balance accounts can benefit from planning because their RMD could cause them to jump into a higher tax bracket. One way to lessen the tax impacts later in life is to consider Roth conversions. When evaluating such a strategy, some tradeoffs need to be considered, which you can learn about in our other article, Roth Conversions – When It Makes Sense and When It Does Not.
Technique for RMDs
If you are charitably inclined or enjoy paying less taxes then Qualified Charitable Distributions (QCDs) are a tax savings technique worthy of further consideration. QCDs allow the IRA account holder to donate up to $100,000 per year from their IRA to qualified charitable organizations of their choosing. In order to qualify, the charity must be an approved organization under Publication 526 of the IRS code, the account holder must be age 70 ½ or older, and the donation needs to go directly from the IRA to the charity.
The primary benefit is that the amount you donate can be included as part of your RMD while simultaneously reducing your taxable income. That’s because QCDs are considered tax-free withdrawals. Let’s use Bob Jones as another example:
Bob and his wife, Cindy, tithe $20,000/year to their church but have always made those payments from their checking account. Bob just turned 73, and his first RMD is $32,000; however, he doesn’t need the money from his IRA. Rather than make their donations from their checking account, Bob and Cindy are better off if Bob directs $20,000 from his IRA to his church. In doing so, Bob reduces his taxable income by $20,000.
In conclusion, while itemizing charitable gifts is a nice tax deduction, the more significant benefit occurs when that amount is repurposed as a QCD. Tax-free is always greater than tax deductible.
RMDs – The Main Takeaway
Whenever confronted with complex information it helps to distill it down into one simple lesson. To that end, the key takeaway from this article is that RMDs are a component of your retirement income plan that demands ongoing planning and attention. Failing to keep up with the rules and regulations can lead to an expensive mistake equal to 25% of the amount that should have been distributed. The more IRA and 401(k) accounts you manage, the more challenging they are to keep up with during the later years of life. If you prefer to delegate that responsibility, let us show you how we can help.
Strategies for Using inheritance dollars now
Suppose you have a detailed financial plan and a strong projection that you will have a significant amount of money left after you depart this realm of existence. In that case, you may think of the best ways to use that wealth now and even after your departure. In this article, we will explore ideas and methods to use your wealth that you may not need after all.
This article marks the conclusion of our Retirement Income Series and is entry #8. To learn about the entire retirement income process from A-Z, we suggest going to our main resource page and starting from the beginning.
LEAVING A LEGACY TO YOUR HEIRS
Once you know what you want to accomplish with your wealth, your next step should be updating your estate planning documents to reflect those wishes. A good estate attorney will hear you out and draft a plan to ensure your assets are handled as you intended after you leave. If you only want to ensure that your wealth is passed on to your intended heirs, a "Will" usually does the trick just fine. If you want to control how your heirs use their inheritance, a Trust allows you to spell out how funds are accessed and spent.
Under the right circumstances, Roth Conversions can be a powerful tool to build up Roth IRA balance and pass tax-free assets to your heirs. We take a deeper dive into this concept in our article titled Roth Conversions When It Makes Sense and When It Does Not.
It is said that each person dies three times: when we die physically, when our body is laid to rest, and the third time when our name is spoken the last time. "Legacy" is defined as "the long-lasting impact of particular events, actions, etc. that took place in the past, or of a person's life." In other words, your legacy does not have to be limited to passing money on to your descendants but instead might include discussing the values you'd like to impart to your heirs; or crafting a family narrative that encompasses more than simply real estate or cash assets. We can all reflect on our family trees and quickly realize that while we may know a bit about our great-grandparents, almost nothing is known about our great-great-grandparents or older generations.
Suppose your legacy focus is on something other than transferring wealth. In that case, you may consider starting a family tradition where members gather every couple of years to discuss and honor family members who have already passed away and update family history record with important events to be used by later generations. If you are interested in this, there are a lot of free resources online, and all you have to do is search for "Legacy Project" ideas.
GIFTING DURING YOUR LIFETIME
Setting up beneficiaries and inking your wishes into a well-written etate plan is a great start, but you could go a step further. Instead of waiting to share the wealth you may not need, you could start giving it away now if you would rather watch your heir enjoy your gifts to them. Family trips and creating new memories with your children and grandchildren is likely far more meaningful than a 6-figure check. The added benefit of giving early is that it can serve as a litmus test to see how someone would manage a larger inheritance in the future.
Gifting during your lifetime could also help reduce the size of your estate and lower your estate tax bill, which is important if your estate is large enough to trigger lifetime exclusion limits. Each person can gift up to an annual exclusion amount of $17,000 per person, per year, without filing IRS Form 709. Taking it a step further, married couples may gift $34,000 to any one person per year and qualify for the exclusion limit. Fortunately, under current law, triggering gift and estate taxes is not an issue for most – the Lifetime Exemption amount is $12.92M per grantor ($25.84M if the surviving spouse properly elects the marital deduction).
One common misconception is that either you or the recipient would have to pay taxes on dollars gifted – not true. Since these rules do not limit whom you can gift assets to, you can give $1,017,000 to your favorite neighbor. While this amount is far in excess of the annual exclusion amount of $17,000, all you would have to do is file a gift tax return.
On the other hand, some assets should never be gifted, especially highly appreciated assets of any kind. While one may think it is a great way to avoid paying capital gains taxes, it is the worst thing you could do because your highly appreciated assets receive a step-up in cost basis upon your death. A step-up in cost-basis allows your heirs to receive those assets with minimal tax consequences compared to gifting the highly appreciated asset to them during your lifetime.
Let's use a common mistake to illustrate how the step-up in cost basis works and can benefit your heirs. A parent decides to list a child as a joint owner of their residence, or even worse, they "deed over the house" completely. Unfortunately, in this situation capital gains taxes are calculated on the appreciation of an asset realized upon sale. For example, if you buy a house for $500,000 and sell it a year later for $1,000,000 – congratulations, you made $500,000, but you must pay taxes on this gain. However, if you buy a house for $500,000 and you die a year later when it is worth $1,000,000, and your child inherits the house – the IRS considers the value on the date of passing as the new purchase price for the child who inherited the home.
This purchase value increase upon death is called a "step-up" in cost basis. So, if the person who inherited the house turns around and sells it right after it was inherited – the capital gain would be $0, and there would be no taxes due. The IRS uses the home's value on the date of your passing as the "purchase price" for your child, so from the IRS perspective, your child got the house for $1,000,000 and sold it for $1,000,000 – no gains to tax. However, if you gift or "deed over" the house – there is no step up in cost basis, and IRS still considers the original $500,000 purchase price as the actual cost of the house, and if the child sold the house for $1,000,000 – there would still be capital gains taxes to pay on the $500,000 gain.
CHARITABLE GIVING
Some consider giving to those in need a moral obligation, while others do so simply because it makes them feel good. Whatever your motivation is, some ways to give are better than others from an estate planning perspective. It is crucial to be aware of a few core concepts.
First and foremost, to qualify for tax deductions, you must give to a legitimate 501(c)(3) organization. This designation means the IRS recognizes the organization you are helping as being tax exempt – which means it is not in the business to make a profit but instead operates as a non-profit entity. If you donate to an organization that does NOT have this designation, while your gift will be appreciated, you will not receive a tax deduction.
Tax Deductions
How much you give to a cause is another important consideration if the tax deduction is a significant factor in why you are giving. Therefore, knowing the rules may determine if you decide to donate or not. Suppose your cumulative deductions are within your standard deduction amount ($13,850 for single filers or $27,700 for those married filing jointly); in that case, your donation will not reduce your taxes. The standard deduction amount is a "default" reduction of your taxable income and is meant to simplify the tax filing process. If you would like to receive the tax deduction for your charitable donation, then the goal is to exceed the standard deduction amount.
Qualified Charitable Distributions (QCD)
You may have heard the term "QCD" used when discussing withdrawals from your IRA, which stands for "Qualified Charitable Distributions." This type of withdrawal denotes a way to take out funds from your Traditional IRAs and pay NO taxes if the distribution goes directly to a charity or a church. We go into more detail about this in the following blog article: How Making a Qualified Charitable Distribution From Your IRA Can Help You.
Donor Advised Funds (DAF)
A less common method of gifting is via a "Donor Advised Fund," often abbreviated as "DAF." An easy way to understand how a DAF works is to think of it as an investment account you can open at a Charity. Once the investment account is opened, you can donate to the DAF and receive a tax deduction for the amount contributed. After funds are in the DAF account, you can assign the charity or charities that eventually receive the proceeds in the account. You can even get as specific as dictating the particular causes you want the DAF funds to go towards and by how much.
The flexibility of a DAF is why they are growing in popularity. In other words, you do not have to distribute the entire balance of this account in any given year, and you can use this account to donate as little or as much as you want during your lifetime. Deferring your donation until later allows the balance of the DAF to be invested and grow over time.
DAFs fit well when someone who is charitably inclined faces a year with substantial income tax liability. In such a year, you can contribute a significant sum to a DAF to offset part of the income tax liability and then spread out the gifts to charities over a number of years. Another way to use a DAF is to incorporate it into your Estate Plan and direct transfers to charities after your passing – continuing to support things you care about well after you are gone.
VOLUNTEERING
Charitable giving does not have to be denominated in dollars or shares of stock. Volunteering your time and expertise to a cause you support may not lower your taxes. Still, it is very important to organizations involved, and knowing you impacted your community feels great. If you are seeking to engage a charity and participate in a hands-on way, go to www.volunteermatch.org to search for your favorite causes.
COORDINATING YOUR ESTATE WITH A PROFESSIONAL
While the legacy and gifting concepts discussed today will give you a good starting point towards optimizing the financial aspects of your estate, a good estate plan requires an in-depth understanding of the legal nuances and IRS regulations that may trigger other unintended consequences. It is best to discuss these strategies with a qualified professional, so that your legacy and gifting goals are coordinated seamlessly with your overall financial plan, estate plan, and ongoing tax planning efforts. Feel free to get in touch with PARAGON if you need an introduction to a well-qualified estate planning attorney.