How RMDs Can Upgrade Your Portfolio

Affluent investors love to hate their RMDs--the required minimum distributions they must take from their Traditional IRA and 401(k)s by the end of each year after they turn age 70 1/2.

They complain that their RMDs push them into a higher tax bracket and muck with their planned withdrawal rates. They wonder about how to reinvest their unwanted, unneeded distributions, as well as how to avoid RMDs in the first place.

The fact is, the best way to avoid RMDs is before they start--or ideally, before you retire. By investing in multiple silos--Roth and taxable, in addition to the RMD-subject Traditional IRAs and 401(k)s--in the years leading up to retirement, you avoid coming into retirement with all of your assets subject to ordinary income taxes and RMDs.

By the time you hit the age for RMDs--which must commence by April 1 of the year following the year in which you turn 70 1/2--dodging those distributions carries tax consequences of its own. True, it can make sense for some RMD-subject investors to consider converting those Traditional IRAs to Roth accounts, which offer tax-free distributions and aren’t subject to RMDs. But the conversions also have the potential to jack up taxes in the year in which they're executed, so the long-term benefits must be weighed against the short-term costs. And for older adults converting Traditional IRA assets to Roth so that their children or grandchildren will be able to take tax-free distributions (a common motivator), it's worth remembering that their own current tax rates--which will be levied upon the amount converted--may well be higher than the taxes their heirs would pay if they inherited those Traditional IRA assets. If the goal is to minimize the taxes levied on that IRA kitty, a conversion won't always achieve it.

Yet while there are few good ways to dodge RMDs and their related tax bills, there's one key silver lining. You can use these forced withdrawals to improve the risk/reward profile of your portfolio--especially its risk level--without triggering any additional tax costs. Whereas rebalancing is often psychologically difficult, RMD season leaves little room for excuses. You have to take those distributions or else face a 50% penalty on the amounts you should have taken but didn't, so you might as well take the ones that make the most sense from a portfolio standpoint.

Strategic RMDs in Action To use a simplified example of how RMDs could help improve a portfolio's risk/reward profile, let's say a retiree allocated her $1 million IRA portfolio three years ago, at the beginning of 2012. She was targeting a 60% equity/40% bond portfolio, so she put $400,000 into a U.S. equity index fund, $200,000 into a foreign equity index fund, and $400,000 into a total bond market index fund.

Fast forward to today: Her portfolio has appreciated to $1,389,040 by mid-November 2015, and its contents have shifted around, too. Her U.S. equity fund now accounts for more than half of her balance, after starting as 40%. Meanwhile, her international equity and bond funds have shrunk below their original position sizes, to 18% and 31%, respectively. They've appreciated in dollar terms, but not nearly as much as the U.S. stock fund in her portfolio. Her bond fund has been the biggest (relative) loser.

She turned age 70 1/2 this year, so she will be required to take her first RMD by April 1, 2016. (Required minimum distributions are normally due by Dec. 31 of each year, but first-time RMDers can take advantage of a special three-month extension.) To calculate her RMD, she'd look back to her balance on Dec. 31, 2014--$1,387,680--and divide that by 27.4, the distribution period for a 70-year-old in the IRS' Uniform Lifetime Table. That calls for a distribution of $50,645 from her IRA.

Because she has multiple holdings with different performance patterns, she can be surgical about which holding she taps for distribution. Assuming she'd like to get her portfolio back in line with her original targets of 40% U.S. equity, 20% foreign equity, and 40% bond, the answer is easy: She should sell a chunk of the U.S. stock fund. Selling $50,645 of that holding is not enough to restore her portfolio to her original allocations, especially because she’s a young retiree and her RMD is a fairly small portion of her total kitty. It has also been a while since she made any portfolio alterations.

But that doesn’t have to be the end of her rebalancing activity. If she doesn't need the RMD for living expenses, she could plow the proceeds into a bond fund in a taxable account, boosting her bond allocation to 35% of her total portfolio, both taxable and IRA--closer to the 40% target. (If she's a higher-income investor, she'll want to consider municipal bonds for her bond holdings inside of a taxable account.)

Of course, she may still wish to take action to restore her balance further to her original allocations, and she can do that repositioning without incurring additional tax costs in her IRA. But the strategic RMD and rebalancing have gotten her at least part of the way there.

Implications for Holdings As the strategies outlined above strongly suggest, having at least a few discrete holdings gives the retiree some latitude to be strategic when taking RMDs. By contrast, the retiree holding a single fund in an IRA--one that combines both stocks and bonds, for example--wouldn't have discretion over which investment type she sells for distributions. Selling the fund would mean that she's selling a chunk of both her stocks and her bonds.

Retirees interested in exerting even tighter control over their portfolios' allocations could consider subdividing their holdings even further than the three-holding IRA in my example above. For example, maintaining separate holdings for small-, medium-, and large-cap exposure; value and growth exposure; and developed- and developing-markets foreign exposure would likely afford even more rebalancing opportunities. But a retirees should weigh the potential benefits of such a strategy against its complexity; when it comes to the number of holdings in retirement--especially in later retirement--less can be more.

Are you looking for tips on improving your portfolio? As part of Morningstar.com's Portfolio Makeover Week in December, director of personal finance Christine Benz will be making over five real-life portfolios to show how investors of all stripes may streamline and upgrade their holdings. To be considered for a makeover, submit a request to portfoliomakeover@morningstar.com. Include a general description of your situation, including portfolio size, as well as your goals for the makeover. We will alert you if we decide to feature your portfolio on the site and will remove any personally identifying information in any published material.