Required Minimum Distributions (RMDs) .. What You Need To Know.
The money in your pre-tax workplace retirement plans and pre-tax IRAs has never been taxed. The IRS wants its money. Here's how it plans to get it from you and what you need to know in advance.
What are Required Minimum Distributions?
I recently published an article on Roth conversions. One of the big incentives to converting pre-tax accounts to Roth that I mentioned was that Roth accounts are not subject to any Required Minimum Distributions (RMDs) in the way that all pre-tax accounts are.
As I mention in the Roth conversion article, when you look at the total balance of all your pre-tax 401k, 403b, 457 plans and/or your Traditional, SEP, Inherited or Rollover IRAs, you need to realize that you probably really only own something like two-thirds of it.
That’s because each and every withdrawal will trigger a tax bill at whatever your marginal income tax rate (state and federal) is at the time of the withdrawal. And, if you die with a balance in one of these pre-tax accounts, your heirs will effectively inherit the tax obligation.
Between the ages of 59 1/2 and 73 (if you were born before 1960) or 75 (if you were born in 1960 or later) you’re in complete control of how much, if any, you want to withdraw from these pre-tax accounts and therefore how much of a tax bill you are generating each time you do so (there will be no additional 10% penalty as long as you are older than 59 1/2 when you start withdrawing).
So, preferably in consultation with a financial advisor and a tax professional, you can be somewhat tactical about your withdrawals in the context of things like your evolving expenses, any residual income you may be earning in retirement or semi-retirement, prevailing tax law and tax brackets, your health, your desire to use the money for something specific and the impact of market conditions on the value of your retirement war chest.
However, that full control over your withdrawals disappears after you turn 73 or 75 as this is when the dreaded RMDs kick in.
A RMD is the minimum amount that you must begin to withdraw annually from the above-referenced accounts by April 1st of the year after you turn 73 or 75.
It is worth noting here that those age thresholds and their associated birth years have been adjusted by Congress from time to time and could possibly be changed again in the future.
How much money is annually forced out of your accounts by RMDs?
The amount of the forced withdrawal each year from pre-tax accounts is calculated according to a pre-set IRS table built around actuarial life expectancy (and therefore could also be subject to adjustments in the future).
Let’s say you were born after 1960 and the balance in your pre-tax 401k is $1,000,000 at the beginning of the year in which you reach age 75, at which time let’s say that you are in the 30% marginal tax bracket (federal plus state) determined by your annual taxable income which would need to include any earnings, Social Security payments plus the amount you will be withdrawing (see here for the current federal brackets).
Your first forced withdrawal will be for $41,000 (4.1% of $1m) and that amount will be added to your income for the year in which you make the withdrawal, resulting in an increase in your state and federal income tax bill of $13,120 (30% of $41k).
For your first withdrawal only, you are allowed to wait until April of the year following the one in which you turned 75 to take the money out, but after that all withdrawals will need to be completed by the end of each calendar year.
For your second RMD, if your balance is, say, $950k on January 1st of that year you will need to withdraw $39,900 (4.2% of $950k) that year which will trigger additional income taxes of $11,970 (30% of $39,900).
Let’s say that at the beginning of your third year of RMDs the portfolio value is now $920k and you remain in the 30% tax bracket. The RMD for that year will be $40,480 (4.4% of $920k) resulting in $12,144 (30% of $40,480) more in state and federal income taxes.
And so on and so forth, year by year according to the table until the account is eventually emptied and the IRS will have finally got its hands on all the taxes owed.
A few points to note from all that ..
RMDs on your current pre-tax workplace plan like a 401k, 403b or 457 can be delayed until you actually retire if you are still working and remain eligible to contribute to the plan at the time you turn 73 or 75. However, RMDs are still required as scheduled on any pre-tax IRAs or any “old” pre-tax workplace plans from previous employers, regardless of your employment status when you reach your threshold age. Rolling these IRAs and “old” plans into your existing in-force plan may make a lot of sense in this scenario.
If you have more than one of the pre-tax account types, the RMD obligation is on the aggregated value of all your pre-tax accounts. If you have multiple pre-tax 401ks, 403bs and/or 457s that are subject to RMDs, you need to make the calculated percentage minimum withdrawals from each and every one of the plans individually. If you have multiple pre-tax IRAs of any kind, you are able to simply make one withdrawal from just one of the accounts to satisfy the RMD obligation resulting from the total of all the IRA accounts.
If, as described above, you do decide to delay your first withdrawal to April of the year after your qualifying birthday rather than making it during that calendar year, that will actually mean that you have to make two withdrawals in that year since your second withdrawal has to be made by the end of December and you will be taxed accordingly on the aggregated total of the two withdrawals made in that calendar year.
Remember that, of itself, the very act of withdrawing the funds has the potential to move you into a higher marginal tax bracket since it is considered as income to the extent of the amount withdrawn.
Obviously the tax bill will change if your income and thereby your applicable tax bracket shifts during retirement or as state and/or federal legislation adjusts the tax percentages payable and/or the income points at which you enter or exit particular brackets.
It’s also obvious that any market-driven gains/losses associated with the account(s) are going to impact the amount of the forced RMD withdrawal, since the whole calculation pivots off whatever the value of your pre-tax investments is on the first day of the year. For example, if the total value of the pre-tax portfolio has actually increased over the course of the prior year due to the investment strategy despite the previous year’s RMD withdrawal, then the next RMD will be higher than the previous one (particularly since, as you can see from the table above, the percentage required to be withdrawn moves a little higher each year).
You can avoid some or all of the additional taxes generated by your RMDs by making Qualified Charitable Distributions (QCDs) which allow you to make tax-free donations (up to a designated maximum) directly from your pretax IRA to a qualified charity, thereby potentially satisfying all or part of your annual RMD without paying income tax on it.
At what time of the year should you take your RMDs?
If RMDs are necessary to support your general lifestyle and expenses then you should simply take them as needed, so that they act rather like a salary. You can make as many withdrawals as you like during the year at whatever frequency and amounts you need, just so long as you have reached the required minimum by the end of the year.
For many people though, RMDs force withdrawals that are not necessarily required for concurrent living expenses which they may be able to cover using other sources like earned income, Social Security payments, pensions, cash savings or taxable or tax-free investment assets.
These people face the question of when to make these required withdrawals from their pre-tax accounts. In a one-time lump at the beginning of the year? At the end of the year? Dribble the money out over the course of the year?
The spreadsheet answer to this is clear. You should make the withdrawal as late in the year as you possibly can.
Here’s why. The stock market is higher 76% of the time on a one-year basis (see below).
So if you have a pile of cash you’re sitting on, the probabilities would tell you that investing it in a lump sum right away is better than dollar cost averaging into the market.
In retirement, you need to invert this line of thinking, meaning that waiting for the last possible moment to sell and taking advantage of the fact that the stock market usually goes up has a better probability to give positive results than selling it all upfront in January.
Whenever you do withdraw your RMDs for whatever purpose, always remember to carve out the amount of the likely resulting tax obligation from the proceeds and place it in a segregated high yield savings cash account so that it is there waiting for you at tax time the following year. You can then spend or reinvest the balance.
Rebalancing using RMDs
Your recommended asset allocation is not static, particularly in retirement. There are two main reasons why you should consider periodically rebalance your allocation.
Market gyrations are going to knock your asset allocation off course. If, for example, you are invested at the recommended allocation for your circumstances of 50% stocks/50% fixed income and then the stock portion moves higher at a significantly faster pace than the fixed income portion (a very likely occurrence based on history), then the allocation will inevitably begin to drift away from the target .. 51/49, then 52/48, 53/47 and so on. If you do not course-correct by rebalancing back to 50/50, you could soon end up with a 60/40 or even a 70/30 portfolio even though the recommended allocation for your situation is still 50/50. This will expose you to bigger losses in the case of a market turnaround that crushes stock prices. This is exactly what happened to a lot of people in the Great Financial Crisis of 2008 who got hurt more badly than they should have done with an excessively risky allocation following years of rising markets beforehand during which time they failed to rebalance.
As you age and your time horizon shrinks, you will need to eventually set up a gradual process of rebalancing to manage the risk in your portfolio. Generally speaking, in your 20s and 30s there is no need to hold bonds in your retirement-destined accounts as you have multiple decades before you’ll ever touch the money. A 100/0 stock/fixed income allocation is entirely appropriate with this kind of time horizon, holding a portfolio made up of entirely of diversified riskier stock assets with a much higher expected rate of return. Maybe in your mid-to-late 40s, you could rebalance to introduce a small element of some lower risk assets, maybe 90/10 or 85/15. During your 50s, this gradual process should continue so that by aged 60 it looks more like 65/35 or so. As you move into your 60s and the time horizon compresses to a decade or less, 50/50 or even lower would seem more appropriate. By the time you reach your RMD age, you need to be frequently rebalancing to take chips off the table at an increasing rate for risk management purposes.
If you use a platform such as Betterment, the process of rebalancing due to market gyrations can be automated as it will use an algorithm to always systematically return you back to your original allocation whenever a particular drift (maybe 3% or so) is detected. Some workplace retirement plans offer an automated rebalancing feature. Otherwise you’ll need use the manual calendar method and rebalance it yourself once or twice a year. This is far more inefficient, imprecise and time-consuming than the algorithmic drift or automated calendar method and, frankly, a pain in the ass to do if you have multiple investments in the account.
RMDs can be used as a tool to efficiently accomplish the age-based process of rebalancing in retirement. Instead of making required withdrawals in the same ratio as the allocation of your entire pre-tax portfolio, withdraw a disproportionately higher amount (or even all of it) from the riskier assets in your account (stocks rather than fixed income) each time which will have the simultaneous dual effect of meeting your RMD obligations and appropriately de-risking your remaining portfolio every year.
What can I do in advance to prepare for RMDs ?
Many of you reading this may be thinking, “I’m nowhere near 75 years old yet, what’s the point in learning all this about RMDs?”.
There are a couple of answers to that.
You may have parents or other relatives heading into the RMD zone and this is all useful material if you want to offer them any guidance.
There are plenty of things you may be able to do now, even decades before you face any RMD obligations, to make your life much easier when you get there.
As you move through the accumulation phase of your life which can last from your early twenties to your sixties or beyond, it is increasingly easy to build up a meaningful Roth retirement war chest which will not be subject to any RMDs.
You can do this through contributions to your Roth IRAs every year (via the backdoor method if necessary) and to a Roth account at your workplace 401k/403b/457 plan if it is offered, with massively increased capability if you are lucky enough to work for an employer that offers Mega BackDoor Roth 401k contributions.
Remember that there is no immediate tax deduction for what you put into Roth accounts in the way that there is for what you put into pre-tax accounts since you are effectively funding them with after-tax dollars. But once in the Roth accounts, the balance will never be taxed again, growth is tax-free forever, no RMDs will ever be applied and you will own a much better legacy asset.
In contrast with the pre-tax accounts, when you look at the total balance of all your Roth IRAs, Roth 401ks, Roth 403bs, Roth 457s, you can be comfortable in the knowledge that the entire amount is yours.
You also have the option to turn some or all your pre-tax buckets into Roth buckets at any time during your accumulation phase, thereby reducing or even eliminating the balance that will be subject to future RMDs. These so-called Roth conversions are the subject of my other article; how to do them, when to do them, who should do them, who shouldn’t do them and, most importantly, the potentially very significant tax implications.
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