Optimizing the tax treatment for required minimum distributions

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Most retirement-age investors know that they need to take required minimum distributions from qualified retirement accounts on a set schedule once they reach 70 1/2.

If these clients haven’t yet established a goals-based financial plan that accounts for all sources and uses of their cash flow during retirement, however, they may not have thought about how to deploy their RMD funds in a way that helps them both cover their expenses and optimize their tax bills.

A goals-based plan can provide additional context that will help clients identify the best role for RMDs in their overall financial strategy. Without one, allocating RMDs too often becomes an afterthought, with many investors stashing the funds in their brokerage accounts or in the bank.

This is especially true of retirees over 70, many of whom have pension income that covers the bulk of their retirement costs.

Financial advisors can help clients address this issue by incorporating the following questions into a conversation about establishing a goals-based financial plan:

  1. If a client has been taking money out of non-qualified accounts to maintain his or her standard of living, can he or she substitute RMDs for those funds instead?
  2. If a client doesn’t need the RMDs for retirement expenses, should he or she consider a partial Roth individual retirement account conversion for the balance of the IRA in order to reduce future tax payments?
  3. Would a hybrid life insurance/long-term-care policy be appropriate? Such policies can provide valuable tax savings over multiple years because they often provide tax-free death benefits for clients who never need long-term care. If clients do eventually need long-term care, these policies may offer tax-free distributions to pay for qualified expenses. Although allocating RMDs to such a policy won’t reduce a client’s tax bill right away, this strategy may produce multiple valuable benefits over the longer term.
  4. If the client has sufficient cash flow from other sources to support his or her lifestyle and goals, can RMDs be used to benefit the client’s family through a tax-efficient vehicle such as a trust? Could the proceeds be donated to charity or contributed to a donor-advised fund?

Once clients come to understand the role that RMD proceeds can play in their broader goals-based and values-based financial plans, identifying the optimal use of these funds in order to help them achieve their dreams and manage their tax bills becomes straightforward and intuitive.
Chad Smith is a wealth management strategist at HD Vest Investment Services in Irving, Texas.

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