Retirement is one of the most important phases of our clients’ lives. Insurance and investment advisors have an extraordinary opportunity to help clients enjoy their retirement the way they desire.
Many clients fear outliving their retirement funds. Much has been written in the popular press about designing a savings plan to attract investments, but little is written about the important tax consequences involving retirement plans and Individual Retirement Accounts (which also are referred to as qualified retirement plans, or QRPs). Although factors such as a client’s age, acceptance of risk, etc., are critically important when designing your client’s retirement plan, it is equally important to consider the tax consequences of distributions when attempting to ensure that clients do not outlive their QRP. If financial advisors understand basic rules concerning the taxation of retirement distributions, they can put their clients at ease and take advantage of many sales opportunities.
Upon retirement (usually age 70½) and after death, the tax laws require taxpayers or their beneficiaries to withdraw a minimum amount (known as the required minimum distribution, or RMD) from QRPs each year. The RMD is determined on an annual basis by multiplying the prior year-end value of the QRP by a life expectancy factor supplied by Internal Revenue Service actuarial tables. During life, most people use the IRS Uniform Lifetime Table, while after death the IRS Single Life Expectancy Table is used to determine the life expectancy of a designated beneficiary. The IRS Uniform Lifetime Table permits maximum tax deferral during a client’s life because it uses a joint life expectancy factor for determining an individual’s life expectancy. The IRS Single Life Expectancy Table uses the life expectancy of a single person, but permits stretching out the required distributions for long periods when young beneficiaries are named.
When designing the actuarial tables, Congress attempted to assure that the funds would outlast the average single retiree. By explaining this basic structure to clients, a financial advisor can dispel their fears of outliving their retirement assets.
Both tables also provide the financial advisor with a hurdle rate that can be used to test the QRP investments. By comparing the hurdle rate with the investments’ actual return, the investment advisor can invest the client’s funds to do better than the hurdle rate, thereby increasing the QRP’s longevity. For example, if the client takes only the RMD starting at age 70½, and the account has a steady 6 percent annual return, the account will have more dollars in it at the client’s death than it did when the client started taking RMDs, if the client dies prior to age 89.
After the client’s death, as long as the beneficiary’s remaining life expectancy is greater than 100 divided by the plan’s annual growth rate, the plan balance will grow faster than the beneficiary’s required distribution amount. For example, if the plan is growing at 8 percent per year, and the beneficiary’s remaining life expectancy is 20 years, the first year’s RMD (one-twentieth or 5 percent) is less than the plan’s earnings for the year (8 percent). Eventually, the beneficiary’s life expectancy is reduced to the point where he is withdrawing more than the year’s investment return. If the plan grew at 8 percent, the crossover point would be reached 12½ years before the end of the payout period. Advisors usually will have substantial QRP assets to manage for a long period of time, due in part to the RMD rules.
There are at least four sales opportunities for financial advisors to assist clients in meeting their post-death distribution goals. One of those opportunities is a relatively recent development. Here is a rundown of all four.
Sales Opportunity 1
Provide adequately for a client’s surviving spouse. By naming the surviving spouse as the beneficiary of a QRP, a client clearly informs you of the desire to provide for the spouse’s continuing lifestyle following the client’s death. The RMD rules are especially favorable to surviving spouses because they permit maximum tax deferral opportunities for a spouse. Due to the extended period of permitted tax deferral, the investments and the investment strategy inside the QRP may need adjustment to adequately provide for the spouse.
Sales Opportunity 2
Add value to your relationship with your client by recognizing the superior asset protection of trusts. Financial advisors often steer clients away from naming trusts as beneficiaries of their QRPs. Yet trusts offer superior asset protection for clients.
Trusts can provide a continuing lifestyle for a client’s surviving spouse, while simultaneously protecting the assets from second (or third) spouses. Trusts also can provide protected receptacles to hold assets and RMDs when desired beneficiaries have creditor problems, are spendthrifts, or are engaged in professions such as medicine, engineering or law in which they are at risk for losing assets in a lawsuit. Finally, special needs trusts are appropriate for disabled children or grandchildren who receive means-tested government benefits.
In order not to jeopardize the superior asset protection available with trusts, financial advisors should urge clients to have such trusts be the designated beneficiary of a QRP. Unless they dismiss the use of such trusts as beneficiaries of QRPs, advisors can help clients achieve their estate planning goals and also help reach those goals by appropriately investing the trust assets.
Sales Opportunity 3
Expand the stretch-out capability of the RMD rules to the actual lifetime (not merely the life expectancy) of beneficiaries. Your client can name a charitable remainder trust (CRT) as the beneficiary. Even with the potential for long stretch-out periods permitted by the RMD rules, they still limit tax deferral to a life expectancy. This period may be shorter or longer than the beneficiary’s actual life.
Should clients truly desire to have their QRPs last their entire lifetime and their beneficiary’s full lifetime, they should consider a CRT. A CRT can provide annuity distributions of at least 5 percent each year to the client, then to the surviving spouse for his or her lifetime and then continue the same 5 percent annuity distributions for the remaining lifetime of subsequent beneficiaries (usually the children). Not only can the CRT provide the asset protection available with trusts, but it can further prolong distributions for an actual lifetime or lifetimes and offer investment opportunities inside the trust for the surviving spouse’s life and the actual lives of the children.
Sales Opportunity 4
New longevity annuities. In recognition of the reality of our increasing life expectancies, on July 1 the IRS issued final regulations that modify the RMD rules to permit the use of “longevity annuities” inside QRPs. These annuities are ignored for purposes of determining the RMD. They permit annuitization no later than age 85, which would be the required beginning date for such longevity annuities. They also pay for the remaining length of the beneficiary’s life. Check with your annuity providers about new products designed to satisfy this new regulation. Such annuities could help clients provide for the surviving spouse and and prevent the spouse from outliving the retirement income.
By understanding the basic structure of the actuarial tables used to determine RMDs and the benefits of trusts, financial advisors can dispel their clients’ fears and achieve sales while helping clients meet their goals for retirement, for providing for their spouses and for passing assets to the next generation.