Retirement planning is a multi-step process that evolves over time and takes into consideration many variables, including your financial goals and how long you may expect to live. Moreover, there is no such thing as a one size fits all retirement plan, especially given the constantly changing regulatory and tax landscape. A traditional individual retirement account (IRA) and an annuity are often part of a comprehensive financial plan. Both allow for tax deferred growth of retirement savings, meaning taxes are not imposed until you withdraw IRA funds or start receiving annuity payments. Each has its own array of complex rules regarding the timing, amount, and tax on distributions, all of which have nuances and implications to you and your heirs.
With a traditional IRA set up at a financial institution, contributions are made with pre-tax dollars and assets grow tax-deferred until distribution. An individual can deduct all or part of their contributions, depending on their income level. Upon reaching age 73 (or 75 if born in 1960 or later), you must begin drawing from the IRA to avoid a tax penalty. Basically, the required minimum distribution (RMD), the minimum amount you must take out of your retirement account, kicks in. Any and all distributions from an individual IRA are taxed as ordinary income. The funds can be used for living expenses or reinvested in another savings or investment account.
An annuity, on the other hand, is a long-term investment contract with an insurance company, where the owner of an annuity makes a lump-sum payment or a series of payments to fund the contract. In return, the owner receives a lump-sum payout or continuing income payment over time. Like individual IRAs, annuity withdrawals are taxed at the beneficiary’s ordinary income tax rate. A qualified annuity, purchased through a workplace retirement account or a traditional IRA, is funded with pre-tax dollars. No taxes are paid until withdrawals are made, and the entire withdrawal (principal and earnings) is taxed as ordinary income. Importantly, RMDs apply to a qualified annuity. Conversely, a non-qualified annuity is funded with after-tax dollars, so only the earnings portion is taxable. RMDs are not required for non-qualified annuities.
As you approach retirement and begin tapping retirement accounts, it is important to review your current situation and future goals, especially in the context of the required minimum distribution and its tax ramifications. Here, we outline some tax strategies to reduce and or eliminate income taxes associated with your RMD:
- Pre-RMD Withdrawals: Whereas RMDs are required at age 73 (or 75 if born 1960 or later), you can start withdrawing penalty-free once you turn 59 ½ (withdrawals prior to age 59 ½ may be subject to a 10% penalty). Taking some withdrawals before age 73 makes sense if your distributions after age 59 1/2 would be taxed in a lower tax bracket than the bracket you expect to be in when the required minimum distributions start at age 73. It is important that the withdrawal amount does not push you into a higher tax bracket. Spreading out withdrawals may keep you out of higher tax brackets and minimize your tax liabilities over time. Such withdrawals can also help make it possible to defer claiming your Social Security benefit, which increases 8% for every year you wait to collect beyond your full retirement age (up to age 70, after which there is no incremental benefit for delaying). However, drawing down your account balance at an early age means you could miss out on potential tax-free growth of the withdrawn funds.
- Roth Conversion: Converting traditional IRA assets into a Roth IRA can result in significant long-term tax advantages. A Roth IRA is funded with after-tax dollars, assets grow tax-free, and so long as you're 59½ or older and have held the account for at least five years, withdrawals of contributions and earnings are tax-free (withdrawals prior to 59½ may be subject to taxes and penalties on earnings depending on how long you have held the account and purpose of the withdrawal). A Roth conversion makes sense for individuals who believe their tax rate may be higher in retirement, or for those who just want the flexibility that tax-free income provides. For those looking to leave a financial legacy, heirs inherit Roth IRAs tax-free, whereas inherited traditional IRA distributions are taxed as ordinary income. Still, a Roth conversion is not without drawbacks. Notably, converted Roth IRA funds are taxed as ordinary income in the year of the conversion, which can lead to a hefty tax bill, especially if the conversion pushes your income into a higher tax bracket. This may also impact your Medicare premium. Taxes on the conversion need to be paid in the year it occurs. Additionally, a Roth conversion is irreversible; once completed, you cannot switch back to a traditional IRA.
- Qualified Charitable Contribution: A qualified charitable distribution (QCD) is a tax-free donation from your IRA to a qualified 501(c)(3) charity (donor-advised funds are not eligible). The QCD can only be used if the owner has reached the age of 70 ½. You cannot claim the QCD as a charitable deduction, but the distribution is removed from taxable income on line 4b of the owner’s tax return. A QCD makes sense if charitable giving is part of your overall financial plan or if you have funds you no longer need. In addition to reducing taxable income which results in lower taxes, a QCD can satisfy all or part of your required minimum distribution for the year without increasing your taxable income, thus lowering taxes. Each individual can donate up to $105,000 for tax year 2024 from their IRA ($108,000 in 2025). The donation must go directly from the IRA to the charity; you cannot withdraw the funds and make the donation yourself.
Both traditional IRAs and some annuities can be left to another person after the owner dies, and beneficiary withdrawals will be taxed as ordinary income. RMD rules vary depending on the type of beneficiary, as well as whether the owner had begun RMDs.
It takes time and effort to grow your nest egg for retirement, and you need to understand how taxes will impact those savings. Each retirement account type has its own array of complex rules regarding the timing, amount, and tax on distributions, all of which have nuances and implications to you and your heirs. Please contact your Relationship Manager to discuss if any of these strategies make sense for you.
