Using Annuities to Minimize Consequences of Withdrawals from Larger Retirement Accounts

Written by Hersh Stern Updated Sunday, October 13, 2024

As more Americans retire earlier and live longer, their need for income security is more crucial than ever. Unfortunately, Social Security is paying an increasingly smaller share of what we need to retire. The need to save for retirement is hitting an all-time high and many Americans are now saving as much as they can in employer-sponsored retirement plans, IRA's, tax deferred annuities and mutual funds, just to name a few options. You've no doubt been asked by your clients to suggest options that are best for them.

Annuities Can Help Avoid Penalties and Taxes

Some of your clients may have been fortunate enough to accumulate $1 million or more, and probably feel like they don't have a thing to worry about. If they aren't careful, however, they could end up forfeiting some of those hard-earned retirement dollars.

Although more Americans are becoming aware of the danger of not saving enough money for retirement, very few are aware of the legislative pitfalls of saving "too much," and do not realize how much can be lost unnecessarily in penalties and taxes.

While participants may begin withdrawing from their tax-deferred benefit plans after age 59½ without penalties, many people contend it is wise to limit their withdrawals in the early years of retirement and live off other savings until they reach age 70½. That is the age at which the IRS mandates a minimum amount must be withdrawn annually, based on an IRS formula.

What many people don't realize, however, is that delaying withdrawals could cost them their hard earned dollars. But as a financial adviser, you can help your clients avoid the 15% excise taxes on "excess distribution" and "excess accumulation" by determining how much money they have upon retirement and where that money is invested.

Here's how it works: The "excess accumulation" tax would apply if any individual were to die with too much money in his or her retirement accounts. For example, if your client were to die at age 70 after having accumulated $3 million, a 15% excise tax totaling approximately $290,000 could be imposed, in addition to estate taxes. The only way to determine if your client's estate might be subject to this 15% excise tax would be to calculate from a predetermined formula based on IRS regulations interpreting Internal Revenue Code section 4980A.

Furthermore, any withdrawals exceeding $150,000 in any given year from all retirement plans combined is subject to a 15% excise tax on the excess, in addition to the regular income taxes on the entire withdrawal. For example, if your client withdraws $200,00 in a given year, the extra $50,000 will be subject to an excise tax of $7,500. If your client's mandatory annual withdrawals would exceed $150,000, you can suggest that the client begin making withdrawals in earlier years in order to reduce the balance in all retirement accounts before age 70½.

If you have clients who are on the verge of retirement and have more than $562,500, keep an eye out for Internal Revenue Form 5329 (return for qualified retirement plan taxes). If this form was filed as an attachment to the 1988 tax return (the last year for making this election) they can option to "grandfather" the amount accumulated in all of their plans prior to Aug. 1, 1986. This would lower their exposure to the two excise taxes described above.

Another pitfall to beware of is the potential 20% withholding on distributions, including indirect rollovers. This law applies to employer-sponsored plans (except SEP's), no matter how much or at what age the distribution is made. If your client's qualified plan is distributed in a lump sum, the money will be subject to mandatory withholding if it's not directly rolled into another qualified plan or an IRA. The withholding, which can be as high as 20%, is determined on the type of distribution.

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For example, if the distribution were subject to the mandatory 20% withholding, the only way your client could recover the amount withheld would be to reinvest the remaining 80% and make up the 20% from another source within the 60-day rollover period. Again, the easiest way to avoid this situation is to make sure that your client rolls over any distributions directly into an IRA or another qualified account.

By taking these measures before a tax problem arises, you can save your client thousands of dollars. Not only will you be providing a valuable service to your client, but you'll also be enhancing your professional reputation as a financial adviser.