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RMD Expertise Can Save Your Clients From Painful Tax Bite

We received the following email from an advisor who might be asking the same questions most advisors ask about required minimum distributions from annuities and income riders.

I am wondering if you can point me to a publication that can help me understand how the RMDs from income annuities are seen by the IRS.

I recently became aware that the payment of an individual retirement account turned into an annuitized contract is able to cover only the RMDs of that specific account. This means that if you have $100,000 annuitized and a 7 percent payout, it covers only the RMDs for that account, leaving the other IRA accounts subject to full RMD withdrawals. Even if the payment for the annuitized contract is equal to the RMD need for all accounts, it can only account for itself. Is that also true of guaranteed minimum withdrawal benefits, as they are technically not annuitized contracts?

I also became aware that if you have a 401(k), a 403(b), an IRA and a profit-sharing account, you will need to take the RMD from each of them. Only like to like can satisfy the RMD requirement. If you had four IRAs, one of those accounts would be able to satisfy the requirements for the others, but not if each is titled differently.

We believe this is one of the most confusing areas of retirement planning. Most advisors are unsure on these particular rules, so let’s take a look and see how the rules apply to annuities and income riders, and how to avoid a nasty 50 percent penalty for your clients.

First, the easy stuff. All accounts that are holding pretax money — usually 401(k)s, 403(b)s, employee stock ownership plans, profit-sharing plans and traditional IRAs — have required minimum distributions. Most of your clients are familiar with this concept, but how to take those distributions is the $64,000 question.

The IRS says you can take distributions out of “like” accounts. Now, we know that I just referred to all these accounts as “similar” because they all hold pretax money, but that’s not actually “like” enough. Each investment vehicle that we just mentioned — 401(k)s, 403(b)s, employee stock ownership plans, profit-

sharing plans and IRAs — is its own separate category. So if a client has two IRA accounts, they may combine their two RMD amounts and withdraw that amount from a single account. But they cannot combine the RMD amounts from their IRAs with their 401(k) RMD amount and take all three RMD amounts out of one account.

The other nice feature about taking IRA distributions is that you do not need to divest your assets to qualify as having taken your RMD. For example, if your client has their portfolio distributed as they like it and has no intention of selling their stocks or bonds, they simply can move the market value that they need from their IRA into an individual or joint brokerage account. This action will qualify for your client’s RMD as long as the market value of the assets is the same amount (or more) as the client’s RMD amount for their IRAs. This means no reallocation of funds for you or your client. Instead, their portfolio can remain balanced, and can be sold or adjusted at a later date as necessary.

What if your client’s situation is a little more complicated and they now have an annuity in their IRA? Having an annuity definitely changes the circumstances. Let’s start with the purchase. Let’s say you have a client who is over the age of 70½, they need to take an RMD from an IRA and it’s in their best interest to purchase an annuity with that account.

The initial purchase of the annuity will not count as that year’s distribution. So a distribution still must take place for that IRA. Now if the client has another IRA, you can combine the distribution from both accounts and take the full amount from the second account.

For example, Mr. Smith, who is 72, has two traditional IRAs, each worth $200,000. You advise him to purchase an annuity in Account A in 2016. Account B is fully invested in stocks and bonds. For 2016, he has RMDs for Accounts A and B, each $12,903. Since Account A’s annuity contract doesn’t start distributing income until 2017, Mr. Smith must take both RMD amounts from Account B for 2016. He decides to transfer $25,806 out of Account B to satisfy his RMDs for Accounts A and B.

If your client has not started to receive income from their annuity but is over the age of 70½, their RMD still will be calculated by the annuity’s fair market value. The FMV is the cash account value. However, if the client has additional features on their annuity that add value, such as a death benefit or income rider, it could be included in the calculation of the FMV and increase the amount of the RMD that must be taken. The Internal Revenue Code describes additional benefits as being calculated at their present value. These benefits could be included in the annuity’s FMV if the additional benefits themselves are 120 percent of the cash account value.

An example to illustrate this completely would be quite lengthy, so let’s say that the insurance company holding the contract most likely will be mailing the client the FMV amount. If it’s not proactively mailed, call the insurance company and ask for help calculating it. It’s a complex calculation, and any miscalculation could cost your client some of their hard-earned money. But you should know that, depending on the additional benefit, it could increase your client’s FMV, which will increase their RMD until they turn on their income or annuitize the contract. After the client starts receiving income, the RMD calculation is no longer necessary.

After the annuity starts to produce income — whether through annuitization or an income rider — the IRA becomes a defined benefit plan instead of a defined contribution plan. So the IRA account is no longer “like” the client’s other IRA accounts that are still contribution plans. This annuity, from which the client is receiving income, now is under a separate section in the Internal Revenue Code that discusses how distributions from defined benefit plans must be taken. The client no longer has to worry about taking RMDs from this IRA because it is being taken care of for them through the regularly scheduled income payments.

However, if the client has another IRA, its distribution is considered separately and must be handled separately. For example, Mr. Clark is age 75 and has two IRAs. Account 1 is an annuity from which he has been receiving annual payments for three years. An RMD is no longer being calculated for this account because it is now a defined benefit account. Account 2 is a bond portfolio and has an RMD of $10,000. All of the $10,000 RMD for Account 2 must be withdrawn only from Account 2. Account 1 cannot cover any of the RMD amount for Account 2.

By becoming an RMD expert, you can save your clients thousands of dollars in unnecessary tax payments. Don’t let improper minimum distribution management happen to your clients. Be proactive in saving them the pain of a 50 percent penalty!  

Kerry Wallingford, RICP, CLU, ChFC, is an insurance advisor and founder of her practice, Wallingford Financial, based in Seattle. Wallingford is a 17-year MDRT member with two Court of the Table and seven Top of the Table qualifications. Kerry may be contacted at [email protected] .

Abigail Vick is a securities-licensed financial professional with experience as an active trader in the broker/dealer sphere. She recently transitioned to holistic financial planning. She may be contacted at [email protected] .

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