Watch out for the “entire interest” rule
Q: Last year I purchased a variable annuity in my IRA. My insurance company recently sent me a statement reminding me that I need to take a required minimum distribution before year-end. I was shocked to discover that my RMD is higher after buying the annuity than it was last year before I bought it even though the investments in my variable annuity are very similar to the mutual funds I owned before. I called my broker, and he confirmed the calculation. I’ve been taking RMDs for several years, but I have never seen anything like this. What’s going on?
A: Your question highlights an interesting wrinkle in the calculation of required minimum distributions. I can’t vouch for the correctness of your broker’s calculation, but I can explain why your RMD is higher. Hopefully, my explanation will help you get answers about your specific situation when you talk with a representative from your insurance company.
As you know, your RMD is calculated based on the value of your account at the end of last year and your age at the end of the current year. Using your age, the IRS establishes what it calls the “applicable distribution period” for your IRA. Your RMD is the value of your account at the end of last year divided by the applicable distribution period. But how do you determine the value of your account?
When you invest your IRA in assets such as mutual funds or individual stocks, you can read the value of your account directly off your year-end statement. However, when you hold other types of assets, establishing the value of your account may be trickier. For example, some investments may not be traded publicly and may require a professional appraisal. Other investments may have economic value in addition to the value that is reported on a year-end statement.
Your annuity is a prime example of this second kind of asset. Many annuities have other benefits besides the underlying investments that have value in their own right. The IRS requires that the present value of these additional benefits also be included in the value of your annuity contract when the RMD is calculated. This is called the “entire interest rule.” The one exception is if the present value of the benefits is less than 20 percent of the value of the underlying assets. Here’s how it works.
Let’s suppose that you are 75 years old with an IRA that was worth $100,000 at the end of last year. If that IRA had been invested in mutual funds, your RMD for this year would have been $4,065.
Now suppose on December 15th of last year you sold your mutual funds and used the proceeds to buy a variable annuity with a minimum death benefit of $200,000. Suddenly, your RMD must include not only the $100,000 value of your investment, but also the actuarial present value of the $200,000 death benefit. Consequently, your RMD will be higher—possibly much higher—than it would have been under the mutual fund scenario. Living benefit riders that allow dollar-for-dollar withdrawals also require calculation of the actuarial present value of the additional benefits.
Most of us are not in a position to calculate the actuarial present value of anything, so we need to rely on the insurance company that issued the policy to let us know what the RMD should be. Fortunately, most are pretty good about it. However, if your insurance company cannot provide you with the information you need, you should talk with your financial advisor or your tax professional. Failure to take the correct RMD, even when it is difficult to calculate, exposes you to significant penalties from the IRS.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to email@example.com.