It's a fact of tax-deferred investing for retirement. Eventually—within a year of reaching the age of 70½—the Internal Revenue Service expects you to begin pulling your savings out of retirement accounts and paying income tax on your withdrawals. These "required minimum distributions" (RMDs) are mandated for 401(k)s and other employer-sponsored plans, as well as for traditional IRAs (but not Roth IRAs).
Yet while there's no way around taking these mandatory distributions, if you use the money to buy life insurance you may be able to provide substantial tax-free benefits to your family.
Although the money you contribute to tax-deferred retirement accounts can grow without current tax erosion, RMDs must begin by April 1 of the year after the year in which you turn 70½. Then you have to take an RMD by December 31 every year thereafter. These RMDs generally are taxed at ordinary income tax rates as high as 39.6%.
If you're still working full-time and don't own the company, you may be able to postpone withdrawals from a plan sponsored by that employer until retirement. But this exception doesn't apply to IRAs.
The amount of the RMD is based on life expectancy tables and the value of your accounts on the last day of the previous year. For example, if you're age 75, the value of all your accounts is $500,000, and your spouse, who is the sole beneficiary, isn't more than 10 years younger than you are, the RMD under the tables is $21,834.
The penalty for not taking RMDs is equal to 50% of the amount you should have withdrawn (or the difference between the required amount and any lesser amount you did withdraw). For instance, if you failed to take any distribution in the example above, the penalty is $10,917, plus regular income tax. In addition, taking an RMD can trigger other tax complications. You might be subject to the 3.8% "net investment income" (NII) tax.
But what if you were to use the money to buy life insurance? Suppose that, in our example, you use the RMD amount, after paying tax on the withdrawal, to acquire a life insurance policy with a death benefit of $500,000. Further suppose that you pay a total of $200,000 in premiums before you die. Your family still comes out ahead by $300,000, and none of the $500,000 in proceeds from the life insurance is subject to income tax.
Choose the policy carefully to reduce the risk that your family will have less money with life insurance than if you invested the premiums somewhere else.
You could sweeten the deal by transferring ownership of the policy to an irrevocable life insurance trust, thus removing the value of the life insurance proceeds from your taxable estate. That could save your family from federal estate tax as well.