How to Reduce The Tax Bill on Your IRA to $0 (or Close to)
By Michael Branch
Ed Slott Master Elite IRA Advisor
What if you could avoid 100% of the income tax on your IRA? Or at least reduce the tax to as close to $0 as possible?
Most IRAs are funded with pre-tax dollars and distributions from these accounts are taxable at the highest rates. If you could find a way to avoid taxes on the distribution, it would be the holy grail of IRA distribution planning. Ahhhh, if only…
While a totally tax-free IRA may seem like something that only exists in your dreams, there are some circumstances in which it may be possible.
Here’s how to make your IRA dreams come true.
Take distributions in a low-income year. Let’s assume that you are over age 59 ½ and you don’t have any penalties on your IRA distributions. Perhaps, you have a year in which you are unemployed. Or a year in which your business suffers a net loss. For whatever reason your taxable income drops to $0. Consider taking a distribution from your IRA up to the amount that would be taxable.
For example, if you are married with no dependents, you might be able to take as much as $20,300 from your IRA tax-free. This is because you are entitled to the standard deduction of $12,400 as well as a personal exemption of $3,950 for you and your spouse. If your itemized deductions are greater than the standard deduction, you might be able to withdraw more. Not only does this save you tax dollars during your low-income year, but it also reduces the required minimum distribution you may have in later years due to your IRA having a smaller balance.
Diversify your income sources. If you planned right, you may be able to get money from a number of sources during retirement: taxable investments, tax-free investments such as municipal bonds and Roth IRAs, as well as tax-deferred investments like your IRA. By diversifying your income sources among various types of accounts, you may be able to take just enough from your tax-deferred IRA to meet your income needs while keeping your tax bill at $0.
In the previous example, you took out up to $20,300 from your tax-deferred IRA. What if you took another $20,000 (just to keep the numbers simple) from your Roth IRA, and received $20,000 in tax-free municipal bond interest? Now your income is a little over $60,000. One third of it from your tax-deferred IRA, all of it tax-free.
Donate part of your IRA to charity. In years past, the IRS has allowed for Qualified Charitable Distributions (QCDs) if you are over age 70 ½ and the QCD is less than $100,000. QCDs are made directly from your IRA and the distribution is not taxable. If you are charitably inclined, they can be a good way to avoid tax on a portion of your IRA. QCDs are best for people over age 70 ½ that do not itemize their taxes.
So far, Congress hasn’t passed legislation allowing the QCD for 2015, but as they have in the past few years, they may. We won’t know until the last minute, naturally.
List your favorite charity as sole beneficiary of your IRA. Donating 100% of your IRA to a charity during your lifetime isn’t a realistic or acceptable option for most people. But what about after you die? What then?
If you list your favorite charity (or charities) as beneficiary on your IRA, they will receive the IRA tax-free upon your death. As a 501(c)3 non-profit organization, they will not be required to pay tax on the IRA. 100% of your money will go to the charity of your choice. 0% goes to taxes.
Concerned about leaving your heirs with nothing while your favorite charity gets your IRA? Consider one of the life insurance strategies described below.
Make smart use of life insurance. A healthy person may be able to purchase life insurance with a death benefit equal to (or greater than) that of the income tax due on your IRA.
Let me explain: Let’s say you have a $1,000,000 IRA. The income tax due on that IRA could be as high as $400,000 or more depending on the state in which you reside.
Life insurance death benefits are income tax free. Depending on your health status, you may be able to purchase enough life insurance to cover the tax bill. Life insurance isn’t cheap, but it’s less expensive than the taxes your beneficiaries will pay when they inherit your IRA.
Don’t have the cash flow to make premium payments? No problem. Just take a distribution from your IRA sufficient to pay for the insurance. Technically, this isn’t exactly tax-free since the IRA distribution will be taxable, but you get the idea.
Leverage your life insurance. The example above assumes you will have just enough life insurance to pay the tax due on your IRA. That’s fine, but this next strategy takes that idea a step further.
Instead of purchasing only enough life insurance to pay the taxes, consider purchasing enough life insurance to replace the entire IRA – $1,000,000 in the above example.
In this case, when you die, $1,000,000 would go to your beneficiaries income tax free through the death benefit of your life insurance policy. At death, your IRA may still be worth quite a bit, maybe $1,000,000 or more.
Consider listing your favorite charity as the beneficiary of your IRA. This way, instead of your heirs receiving a $1,000,000 IRA with $400,000 or more going to income taxes, they get the full $1,000,000 from life insurance and your charity gets your $1,000,000 IRA income tax-free. Now that’s win-win.
Think you cant afford life insurance? If you are a healthy 70 year old, your IRA required minimum distributions may be enough to cover your premiums.
Assuming you don’t need the RMD for your own benefit, you could use it to buy a life insurance policy that would provide income-tax-free benefits when you die. If you want to lower premiums even more, consider what is called a “second-to-die” policy. In these policies, the insurance company pays a death benefit when both you and your spouse pass away. Since its based on two lives, these policies are usually less expensive and easier to qualify for.
Getting the most from your IRA. Some of the above ideas may be a stretch, but getting the most from your IRA means making the best use of these assets. Sometimes that may mean giving highly taxable money like an IRA to charity or using life insurance to leverage the net, after-tax value of your IRA when you die.
While it may take some careful planning and even a health dose of creative thinking, you may be able to withdraw at least a portion of your IRA without paying taxes.
Mike Branch, CFP(R) is a CERTIFIED FINANCIAL PLANNERTM professional who helps clients cross the bridge from work life to life in retirement. He specializes in late-stage college planning and retirement planning. His blog, The Bridge, can be found at www.mikebranch.net.
Contact him at [email protected]
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