Tue, 3 Feb 2015
Investors may consider gifting the money or steering it into tax-managed or tax-efficient investments, says Morningstar's Christine Benz.
Jason Stipp: I'm Jason Stipp for Morningstar. Investors age 70 1/2 must take so-called required minimum distributions from their Traditional IRAs and company retirement plans by Dec. 31 of each year. But they can and should reinvest that money if they don't need it. Here to offer some tips on that is Morningstar's Christine Benz, our director of personal finance. Christine, thanks for joining me.
Christine Benz: Jason, great to be here.
Stipp: RMDs--let's talk first about what these are, why they are necessary, and why the government requires them.
Benz: My mom asks me that every year around the end of the year. The reason is that the IRA or 401(k) or whatever company retirement plan you are using gives you tax-deferred compounding on your money; but at some point, the government wants you to start taking money out so that you can pay taxes on that money. You get a free ride for a certain percentage of time; but then at some point, you do have to start paying taxes.
Stipp: So, because these are required distributions from your retirement accounts, it's really important to pay attention to what those requirements mean and what those distributions mean for your overall spending plan.
Benz: That's right. So, this is especially important if that IRA, 401(k), if those assets that are subject to RMDs are the bulk of your retirement portfolio. You need to stay plugged into that percentage withdrawal that you are taking. One thing to keep in mind is that even though RMDs start out well below 4%, which is oftentimes thrown around as kind of the guideline for safe withdrawal rates, they quickly escalate, because they are based on a life-expectancy factor.
As your life expectancy declines, you need to take more and more. So, by the time you are age 85, for example, your RMDs will amount to about 7% of your IRA or 401(k) portfolio. By the time you are 90, it's about 9% of your portfolio. So, this is not going to be an issue if you have a lot of other assets that aren't subject to RMDs that you are not touching. It won't be a big deal; you won't go outside your planned withdrawal rate. Another thing to bear in mind is that our colleague David Blanchett, who is head of retirement research for Morningstar Investment Management, has said that he actually thinks that these life-expectancy factor tables that are used to calculate RMDs could reasonably help guide retirees on their overall distribution plans. Because as your time horizon shrinks, you can arguably take more and more of your portfolio, because your life expectancy is that much shorter.
Stipp: So, let's say that my RMD is more than I want to spend. I have a few options with what to do with that money. So, how should I think about that?
Benz: Well, one of the first things that comes to mind is that gifting is certainly an option if you do have excess RMDs--either to individuals or you might even consider contributing to a Roth IRA on behalf of maybe a child or grandchild. That's one idea, assuming that the child or grandchild has at least enough earned income to cover the amount of contribution for that year in which you'll make the contribution. That's one idea.
Gifting to charity, I think, can be another idea. Congress typically renews a provision at the end of every calendar year that allows retirees [who are] subject to RMDs to steer those RMDs directly to charity. The nice thing about doing that is that the contribution doesn't hit the retiree's adjusted gross income. So, it helps lower their tax bill for the year even more than would be the case if you made a contribution and later deducted it on your taxes. So, that's another really interesting strategy. Even if the window has closed to take advantage of that special charitable RMD provision for 2014, you can still think about it for the years ahead. And at a minimum, you can think about steering at least some of the RMDs that you don't need to charity, and then you can deduct it on your tax return.
Stipp: And another option, of course, is to reinvest that money. What kinds of accounts, though, can I shuttle that money into? Can I get it back into another tax-advantaged account?
Benz: Unfortunately, you cannot get it back into a Traditional IRA or back into your company retirement plan. But you can, in fact, invest in a Roth IRA, assuming that either you or your spouse has enough earned income, not meaning Social Security income, not income from your portfolio, but earned income to cover the amount of the contribution. You can invest in a Roth IRA. That won't be an option for a lot of folks who are post-age 70 1/2. So, in that case, their investment receptacle will be a taxable brokerage account.
Stipp: So, when I'm thinking that maybe this money has to go into a taxable brokerage account, what should I keep in mind, because that's obviously going to have different tax implications for me now?
Benz: It will. And so, the key thing you want to keep in mind is that you are going to try to mimic the tax characteristics that you had when you were investing inside of the IRA. So, you want to, generally speaking, steer clear of those securities that will kick off a lot of ordinary income that will be taxed at your highest ordinary income tax rate. You also want to be careful about owning securities that will tend to generate a lot of short-term capital gains--again, taxed at your ordinary income tax rate. So, high-turnover equity funds, high-income-producing bond funds will tend not to be a great fit for investors' taxable accounts. The same goes for, say, dividends that do not receive preferential dividend tax treatments. REITs, for example, would be investments that you want to steer clear of. You'd want to focus on those investments that are pretty tax-efficient on a year-to-year basis to try to reduce the drag of those taxes.
Stipp: If I am, though, hoping to have a shorter-term investment with that, what would be my options to try to be tax-efficient if I needed some income from this?
Benz: There, you want to look at whether municipal bonds or even a municipal money market fund might not be the more appropriate choice for you. It really does come down to your tax bracket and also any state taxes that you are paying. Morningstar has a bond calculator that has a tax-equivalent yield function that you can use to kind of do a head-to-head comparison with some sort of municipal product--some sort of taxable product. You can see, once those tax effects get factored in, which sort of product is the better bet for you. But generally speaking, if you have a pretty short time horizon for the money, cash and bonds is where you need to be.
Stipp: And if you have a little bit longer [time horizon], maybe consider a muni if the tax-advantaged yield looks like it could beat a taxable bond. What if I have a longer time frame, though? I want to maybe reinvest this money and use it several years out. How should I be tax-efficient there?
Benz: Well, I think you want to think about your time horizon again. So, I would say if someone has a time horizon of maybe five to 10 years for the money, one idea would be kind of a balanced product. And considering that you'd be investing within a taxable account, one fund I would recommend is Vanguard Tax-Managed Balanced (VTMFX). It's about 50% equity/50% muni bonds. And the idea is that it is very tax-efficient on a year-to-year basis. It's a really terrific core holding for investors' taxable accounts. Historically, when we look back on its tax efficiency, it has been very, very good.
Stipp: Then lastly, let's imagine I have a very long time horizon. Maybe I would want to even leave some of this to my heirs. What would be an even longer-term option for me there?
Benz: Well, here again, I think you want to focus on tax efficiency. But certainly, if you have a time horizon that you think is going to be 10 years or longer--maybe you expect to leave money to your heirs many years down the road--I think, here, an all-equity portfolio is perfectly appropriate. And of course, broad-market exchange-traded funds can be very nice tax-efficient holdings. Also, tax-managed funds make a lot of sense in this slot as well. Here again, I would mention a Vanguard product--probably Vanguard Tax-Managed Capital Appreciation (VTCLX) would make a nice choice in this slot as well.
Stipp: Christine, a lot of our viewers probably do have some RMD funds sitting around after last year. Thanks for helping us figure out how to deploy those funds.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
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