IRA Tax Bomb

For most people, tax-deferred traditional 401(k)s and IRAs become their biggest assets over time. And while it's good to have a large nest egg, many people don't understand the potential tax ramifications during retirement, or the potential tax burden left for their heirs, in the form of ordinary income taxes due on required distributions and withdrawals from non-Roth accounts. Here are two of the tax bombs that await.

Taxable 401(k)s and IRAs

While most investors consider their traditional, tax-deferred non-Roth 401(k) and IRA accounts the foundation for retirement, often when they reach age 59½ (when they're legally allowed to take withdrawals), they defer and wait until they legally must take them, paying ordinary income tax on the amounts withdrawn.

IRS-Mandated RMD (Required Minimum Distribution) Dates¹

RMD age by year:

• 2023–2032: RMD age is 73
• 2033 and later: RMD age is 75

RMD start age by birth year:

• 1950 or earlier: starts at 72
• 1951–1959: starts at 73
• 1960 or later: starts at 75

Ordinary income taxes are due on amounts withdrawn from non-Roth accounts.

Taxes During Retirement, Including Social Security

RMDs, the mandated distributions from traditional, non-Roth retirement accounts, may cause you to pay more in income taxes than anticipated during retirement. And be aware that even your Social Security benefits may be taxed. Since 1984, Social Security benefits may be taxed up to 85% based on your annual "combined income" calculation: your adjusted gross income, plus any nontaxable interest, certain other income, and half of your Social Security income.²

Joint filers with combined income between $32,000–$44,000 pay taxes on up to 50% of their Social Security benefit; those above $44,000 pay up to 85%.

Taxes Owed by Beneficiaries and Heirs

Perhaps the biggest tax bomb, and one not yet fully understood by the public, is the tax burden left for non-spousal heirs who inherit traditional retirement accounts. Due to the SECURE Act, most non-spouses who inherit a taxable retirement account like a 401(k) or IRA (with some exceptions) must:³

• Take annual RMDs and pay income taxes on amounts withdrawn based on the original owner's timetable, and
• Completely liquidate the inherited account within 10 years and pay taxes on the entire remaining balance.

This can push heirs into higher tax brackets, potentially the highest federal bracket. Including state taxes, heirs may pay over 40% of what was left to them in taxes. If the estate is large enough, IRAs can become an even bigger tax bomb if heirs face double taxation without proper planning.

Options for Defusing the Tax Bomb

Roth Conversions Conducting a series of Roth conversions (paying taxes on the conversions before or early in retirement) is one option for defusing the tax bomb before it goes off. Roth conversions convert taxable retirement money into after-tax Roth accounts, with taxes paid in the year of conversion. These must be done carefully, as they cannot be undone. Work with your tax professional.

As long as the Roth account has been open five years or longer and you're at least 59½, withdrawals and gains are tax-free, and RMDs are not required. The same applies for beneficiaries, though non-spousal heirs must still drain the account within 10 years of inheritance.

Another Option: Life Insurance For those 59½ and older in relatively good health, another approach is taking IRA distributions and directing that money into tax-advantaged life insurance, rather than leaving assets in traditional accounts until RMDs force the issue. This strategy can provide a leveraged, tax-free death benefit for beneficiaries, and may allow tax-advantaged access to funds during your lifetime through policy loans against the cash value.

Important: policy loans are not the same as withdrawals of gains — they accrue interest, reduce the death benefit if unpaid, and can convert previously tax-free proceeds into taxable income if the policy lapses with a loan outstanding. Discuss this strategy in detail with your financial, tax, and insurance professionals before acting.

Case Study: Mr. & Mrs. Jones

Hypothetical example. This does not represent an actual client of Cornerstone. Individual results will vary based on product selection, health underwriting, index performance, policy costs, and contract terms.

Mr. and Mrs. Jones, ages 60 and 57, have two adult children and several grandchildren, $1,000,000 in a traditional IRA, and $5,000,000 in non-qualified assets. They don't need income from the IRA (they were previously advised to push distributions to RMD age) but want additional tax-free income available at age 75 and have considered Roth conversions.

Proposed solution: an IUL (Indexed Universal Life) policy. Mr. Jones can begin taking distributions from his IRA today, at age 60, and potentially leverage those withdrawals for a tax-free death benefit and tax-free income in the future by purchasing an IUL policy.

Assuming Mr. Jones withdraws $50,000 per year for 12 years from his IRA and uses the money to fund an IUL policy with an A-rated carrier, in this hypothetical illustration the Joneses could have:

• A $1,061,849 immediate death benefit. If Mr. Jones were to pass away shortly after the policy went into effect, his beneficiaries would receive this benefit plus his traditional IRA amount of $1,000,000, minus the first $50,000 premium. Heirs would still have to take RMDs, pay taxes, and empty the remaining $950,000 in the traditional IRA within 10 years of inheritance.
• A potential $2,478,735 death benefit at age 90. Not guaranteed; based on historic S&P 500 and Nasdaq 100 average returns, if no loans or cash are taken out and the policy remains in force. Total premiums paid: an estimated $600,000.
• A potential $875,845 cash value at age 75. Also not guaranteed; available to borrow against for any purpose, including retirement income.

The Joneses' IUL policy also provided up to $500,000 in an accelerated death benefit in the case of terminal or chronic illness.

Optional funding strategy: using an FIA to pay for IUL. Because an IUL policy has multiple years of premium payments, a popular funding vehicle inside a client's traditional IRA is a fixed indexed annuity (FIA), which can provide the money to pay IUL premiums. In this example, Mr. Jones takes a $500,000 direct rollover to fund an FIA with a 20% cash bonus and a high liquidity provision beginning Year 1, for an immediate $600,000 value, with a 10% free partial withdrawal (30% cumulative) available to fund the IUL premiums. The remaining $500,000 stays in the traditional IRA, potentially worth $1,000,000 in 12 years using a hypothetical 6% annual return.

Conclusion: Instead of waiting to take traditional IRA distributions until RMDs begin at age 73, and paying the heavy tax burden, the Joneses can take earlier withdrawals while still healthy, leveraging life insurance and using a fixed indexed annuity as the funding vehicle for the guarantees. This can potentially improve their financial situation in case of an unexpected tragedy, and also potentially leave a larger legacy for beneficiaries, in most cases tax-free.