RMD Sticker Shock? How to Ease Your Tax Burden

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Microsoft faces a hurdle to buy the owner of the Call of Duty franchise. I’ll tell you why Morningstar analysts think the deal will likely close. Plus, the clock is ticking down on taking required minimum distributions this year. Morningstar Inc’s director of personal finance Christine Benz asks tax and IRA expert Ed Slott for last-minute tips. And, workers could soon see new investment options in their retirement plans. The Labor Department has eased rules involving ESG funds. Our team discusses what the rule change could mean for workplace retirement accounts. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

The FTC Tries to Block Microsoft

The U.S. Federal Trade Commission is trying to block Microsoft’s MSFT attempted buy out of Activision Blizzard ATVI. The FTC has filed a complaint. The agency says Microsoft could use its control over the video game publisher’s franchises to harm competition. It argues Microsoft could manipulate pricing, reduce the game quality or player experience on rival consoles, or totally withhold titles from competitors. Morningstar believes the major sticking points in terms of franchises are Call of Duty and its Battle Royale spinoff, Call of Duty: Warzone. Microsoft and the FTC will now have to argue over whether the deal is anticompetitive before an administrative law judge. This’ll all take time, so we don’t expect the deal to wrap up until the second half of 2023, if not 2024. We still believe the buyout is likely to be completed, as Microsoft will likely make the concessions required. We’re maintaining our $320 estimate of what we think Microsoft’s stock is worth, and $92 estimate for Activision’s stock. Morningstar considers the shares undervalued.

Campbell Cooks Up A Strong Start to the Fiscal Year

Campbell CPB cooked up a strong start to the fiscal year but the numbers don’t tell the full story. The company was able to offset the rise in inflation with pricing and cost-cutting measures. But, it was lapping bleak year-ago results, during which sales slumped. Morningstar acknowledges Campbell’s prudent strategic focus. However, macro and competitive pressures are heating up. Consumers are already facing higher prices at the grocery store. That could continue into next year as Campbell expects costs to continue to inflate. Campbell is also facing competitive headwinds. They’re forcing management to step up promotional spending through the remainder of the year. Morningstar is sticking with the $53 estimate of what we think the stock is worth. We suggest investors wait for the shares to come down in price before buying.

Chewy’s Quality Q3 Earnings

Chewy’s CHWY push to become the one-stop online pet shop helped lead to a quality earnings report in its third quarter. Chewy beat Morningstar expectations with more than $2.5 billion in sales due to a big boost in spending from active customers. Management expects to add to that sales number in the fourth quarter, pointing to lofty autoship penetration. The company shows remarkably stable demand once a subscriber has joined. We believe the market frequently overlooks this point. Chewy is also looking to new categories like pet insurance and healthcare to boost sales. The pet category is recession-resistant, with consumables and pet healthcare growing nominally through 2007-09. We expect to slightly raise our $43.50 estimate of what we think the stock is worth. We consider shares fairly valued.

Labor Department Eases Regulations Involving ESG Funds

Employees could soon see new investment funds in their 401(k) plans. The Labor Department has eased regulations involving environmental, social and governance or ESG funds. The Biden administration is reversing Trump-era rules. There is discussion about what the rule change could mean for the future of workplace retirement accounts. Two people from Morningstar Research Services are joining Investing Insights to talk about the regulations. They are associate director of sustainability research Alyssa Stankiewicz and manager research analyst Megan Pacholok.

Before we dive into the rule change, Megan, can you explain what plan sponsors like employers are required to do when creating retirement plans?

Megan Pacholok: That’s a bit of a loaded question, and there are a couple of regulations and rudimentary requirements that a plan sponsor, like employers, are subject to make. Some of them include having a written policy that describes their benefits as well as the day-to-day operations. It could be having a recordkeeping platform available or a trust that manages the assets of that plan. If you’re asking from a more investment-focused side, so the fiduciary element of selecting the funds that go into that plan, that includes selecting investment options that are in the best interest of the plan beneficiaries or participants, creating a diversified lineup for them to choose from and keeping the expenses of that plan reasonable.

Hampton: Now, the Trump administration set rules that the Biden administration decided not to enforce. Alyssa, what was the Trump-era policy concerning ESG funds?

Alyssa Stankiewicz: One thing that was consistent about the Department of Labor’s stance under the Trump administration was the importance of the fiduciary duty. And so, as Megan just mentioned, a fiduciary may not subordinate the interests of the participants or beneficiaries in those plans under the plan to any other objectives and may not sacrifice investment return or take on additional investment risk to promote nonpecuniary benefits or goals. That has stayed consistent. What changed under the Trump administration was the interpretation of pecuniary and nonpecuniary factors. The Trump-era rule said very clearly that nonpecuniary factors could not be considered by a fiduciary and strongly suggested that ESG issues were hardly ever pecuniary in nature. If the plan fiduciary were to consider nonpecuniary factors in the process of selecting investment options for the plan, there were a few additional requirements that they had to fulfill. So, they had to document very clearly why the pecuniary factors were not sufficient to select this investment, how the selected investment compared to all of the other alternatives, and how the chosen nonpecuniary factor is consistent with the interests of participants and beneficiaries. Furthermore, the Department of Labor under Trump made it very clear that that fund would not be deemed a qualified default investment alternative, or a QDIA.

Hampton: Now, Alyssa, what are the changes under the Biden era?

Stankiewicz: So, as I said, the interpretation and importance of fiduciary duty remains part of the guidance from the Department of Labor. And the Department of Labor actually openly acknowledged that although that’s been consistent, there have been differences in the tone and tenor of the guidance from the department over the past 40 years, which have contributed to a fair amount of confusion on the topic. So, the Biden-era Department of Labor did a few important things. They removed those additional Trump-era requirements that I just listed out. They added the provision that fiduciaries could designate ESG investments as a qualified default investment alternative. And that means that plan administrators can consider ESG and climate change factors when they’re selecting managers for those funds. One thing that the Biden-era guidance did not include from the original proposal was the provision that would have required plan fiduciaries to require ESG factors. So, they did tone that down a little bit.

Hampton: All right. Megan, Alyssa just mentioned qualified default investment alternatives, or QDIAs. And employers, sometimes they use these for workers who make retirement contributions but don’t make investment choices. What do employers typically pick here?

Pacholok: Target-date funds. The majority of QDIA options are target-date funds. And as a result of that, we’ve seen that target-date industry really garner a lot of assets. It’s now an over $3 trillion asset industry. Why does that make sense? It makes sense for a number of reasons. The first: A target-date fund is really supposed to be your total wealth and retirement savings plan. The other one is if an investor is already not trying to select the investment that they’re making, the target-date fund has a professional portfolio manager behind it that makes the asset-allocation decisions for you. It selects the underlying funds, it rebalances, and it monitors the performance and makes sure that it’s in line to help an investor save for retirement and reach that goal. So, target-date funds continue to make sense as the QDIA.

Hampton: Now, Alyssa, how could ESG funds factor in here?

Stankiewicz: So, in some ways, ESG funds have been available to plan participants such as there are actually two that we track here at Morningstar, ESG-focused target-date plans. So, Megan just outlined all of the benefits of those that are available today. And that’s the Natixis Sustainable target-date strategy, as well as the BlackRock LifePath ESG strategy. Those were launched fairly recently, and they wouldn’t under the previous guidance have been allowed to be the qualified default investment alternative, but plan sponsors could have offered them as an option. So, plan participants could have gone into their retirement plan menu and opted into those target-date plans, if they so choose. Another way that ESG funds could have factored in is by offering individual ESG-focused funds as part of the plan menu. And so, plan participants could have customized their retirement plan even further by opting into those funds. But it’s been limited.

Hampton: Alyssa and Megan, you have different perspectives about the adoption of ESG funds in workplace plans. Alyssa, let’s start with you. What are your thoughts?

Stankiewicz: I think the impact of this rule change is potentially pretty significant. One reason for that is that we’ve seen demand for ESG-focused funds growing over the past few years globally and in the U.S., and even in a challenged market environment, we’ve seen that that demand has been pretty sticky. Another factor here is that retirement plans constitute the majority of investment assets for most Americans. So, this opens a massive door for investors and employees across the country that are interested in ESG-focused investing, potentially to better integrate that interest with their retirement plans. But it does depend on plan sponsor decisions following this rule, and I’m not sure how many plan sponsors will start offering ESG plans as the QDIA. The fact that they’re allowed to now, though, is huge. Because when they weren’t allowed as QDIA’s, we heard that as a major barrier for asset managers that were either considering launching an ESG-focused version of their target-date plan or that already ran an ESG-focused target-date plan and just didn’t see a lot of demand.

Hampton: Megan, can you weigh in?

Pacholok: I’m a bit more skeptical, especially if you’re thinking about sustainable options as a QDIA. As Alyssa mentioned, there are a few options already in the marketplace, and they have a bit of a track record, especially if you’re thinking of BlackRock LifePath ESG Index and Natixis Sustainable Future. So, they have been available for investors. And a bit of a hurdle could have been that the changes coming out from the DOL and their regulations around it. But I don’t think that plan sponsors are going to be rushing to these options and making the changes right away. If anything, it will be more of a slow trickle. Another reason and another hurdle for potentially not having an ESG option as the QDIA are a lot of recent lawsuits around target-date funds used as the QDIA. In most cases, it’s either been around the fees or the performance, more recently. And I don’t think plan sponsors are going to be as willing to adopt ESG as a potential new angle for lawsuits. Even with this new regulation, I think they’re going to be a bit more cautious as to what they’re putting out and selecting for their lineup.

Hampton: All right. Well, thanks Megan and Alyssa for this discussion about ESG funds in workplace plans.

Pacholok: Thank you.

Stankiewicz: Thank you.

Hampton: Thanks Alyssa and Megan for your insights into the discussion about ESG funds in workplace plans.

Some retirees might be experiencing RMD sticker shock. This year’s required minimum distributions need to come out soon—likely from retirement accounts with lower balances. Morningstar Inc’s director of personal finance Christine Benz asks tax and IRA expert Ed Slott about how to reduce the tax bill.

Tips on Taking Last-Minute RMDs in 2022

Christine Benz: Hi, I’m Christine Benz from Morningstar. Time is running out for people who are aged 72 and above and need to take their required minimum distributions from their IRAs and other retirement accounts. Joining me to discuss what you need to know about RMDs is tax and retirement planning specialist, Ed Slott.

Ed, great to see you.

Ed Slott: Thanks, Christine.

Benz: Let’s talk about required minimum distributions, specifically for people who are age 72 and above. What types of accounts are subject to RMDs?

Slott: Basically, all retirement accounts—that’s your 401(k)s, IRAs, 403(b)s. But there are exceptions for certain accounts like a 401(k), if you’re still working, you can delay RMDs until you retire, not from an IRA. From an IRA, there’s no real exception there. Once you hit 72, you have what’s called a required beginning date, that’s April 1 of the year following the year you turn age 72. That’s when RMDs begin. Actually, the RMDs begin for the year you turn 72.

Benz: Roth IRAs, though, are indeed a carve out that if you have Roth IRA assets, and this is one of the reasons you’re such a fan, you do not have to take those RMDs.

Slott: That’s right. Roth IRAs can grow at your own schedule. You never have to take that money out in retirement. And if you do, it’s generally going to be tax-free. So, yeah, you don’t have to worry about RMDs for Roth IRAs.

Benz: There were these new RMD tables that were introduced for this year, for 2022. What are the key differences in those calculations versus the 2021 tables and the ones that were in effect before?

Slott: They were in effect for years and years, somewhere around 20 years. So, they finally updated to reflect current life expectancy. But it adds a little. It helps you a little. It adds about a year or two more of life expectancy, which lowers your required amounts, which in essence would lower your tax bill slightly. Don’t expect a giant savings.

Benz: People who are calculating their RMDs for 2022, many of them have seen their portfolios shrink a little bit. But they may be in for a sticker shock when they calculate their 2022 RMD because it’s calculated based on the 2021 balance. Can you talk us through that?

Slott: That is probably the number one question we’re hearing from people, even advisors, which I’m surprised at, because you just said it correctly. People say, “Well, my account is down. Why should I take such a large RMD? Now it’s a much larger percentage of my balance.” Because as you said, that RMD for, say 2022 now, was locked in on Dec. 31 last year based on what was then a very high market value back then. So, that’s locked in even if now it turns out a greater percentage of your account balance that’s went down. So, you still have to take that amount. There’s no breaks for account balances going down. But people ask that all the time.

Benz: You have to take that RMD before the end of this year. Your 2022 RMD has to come out before Dec. 31, and you shouldn’t wait until the last minute. One question that comes up a lot in the realm of RMDs is how to reduce them. Can you give us a couple of ideas for people who either are thinking pre-emptively and aren’t yet subject to RMDs, or maybe are subject to RMDs and want to try to find a way to reduce the tax bill associated with them?

Slott: Well, there’s a few ways to do it. But before I say that: RMD, the M is a minimum. That’s the minimum. That’s what the M stands for. Required minimum distribution. I wouldn’t focus on that so much. Maybe think that the M might be maximum. Maybe you want to take more. You have to look at the long-term big picture. Let’s say, the Congress was toying with—sometimes they eliminate RMDs when there’s a crisis or there’s some even proposals to raise the age to 73, 74, 75. Let’s say they raise it to 80. They didn’t. I’m not saying that. But the more they raise it, the more you can put off RMDs, the shorter window all your money has to come out because after the Secure Act, you only have 10 years on the back end for most beneficiaries. So, the more you put it off, the larger the overall tax bill will be for you and your beneficiaries. That said, you can reduce RMDs once they begin by doing something like qualified charitable distributions. If you’re charitably inclined, and you give to charity anyway, the QCD can satisfy your RMD amount if you do it in the right order up to $100,000 a year per person, not per IRA account, per person. So, that’s one way.

Another way to reduce or put off RMDs is if you happen to be still working, say, in a company plan. Now, that still-working exception where you can delay only applies to the company plan, but maybe they allow rollovers in from your IRA to the plan. Now, you can’t roll over a required minimum distribution. That has to be taken. But once you satisfy that, if the plan allows rollovers in, maybe you can put that off until you retire. But again, you’re putting off a bigger tax problem. You have to look at the long-term big picture. And the item you mentioned, I’m a big fan of, I call it pre-RMDs. Because maybe you should look at voluntary RMD—if I used the word voluntary, they’re not required. But maybe in your 60s, not before 59.5, because then there could be a penalty, start a long-term plan to start spreading out distributions, taking advantage of these low tax brackets over many years. Because once RMDs start, for example, Roth conversions are constrained. You can’t convert an RMD to a Roth. So, they cost more at that. You can convert once you satisfy your RMD, but then you have to take more out. But look at a plan maybe in your 60s to start taking small amounts voluntarily, not required, to reduce IRA balances and get those out at lower rates. It’s true; the funds will no longer be tax-deferred, but if you can get them out at lower rates and put it into a Roth IRA before RMDs begin, by the time you hit age 72 and RMDs begin, you may have very little or maybe even no IRA left, and you’ll save money on RMDs, save taxes for the rest of your life.

Benz: Last question for you, Ed, relates to the timing of taking these distributions. Obviously, the clock is ticking for 2022. People need to get the funds out of there. But if they’re thinking forward and thinking about the best time of year to take their RMDs, do you have any advice there?

Slott: Well, if they’re doing these QCDs, don’t do the RMDs first. Do the qualified charitable distribution first because it can offset the income from an RMD and satisfy it if it’s enough of an amount. So, that’s one thing. If you’re taking it toward the end of the year like people do because they don’t want to take it before they have to, I wouldn’t wait till the last two weeks of December or so, because—I think I tell you this every year—but anybody who knows anything at these fund companies knows to take the last two weeks off because the telephone calls are insane—not only RMDs, all kinds of year-end transactions. It’s a zoo over there, and they can’t keep up with it. I would say try and get everything done two weeks before the year ends. Remember, it’s a 50% penalty on the amount of the RMD you didn’t take.

Benz: Ed, great advice as always. Thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz from Morningstar.

Hampton: Thanks, Christine and Ed. Subscribe to Morningstar’s YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to podcast producer Jake VanKersen who puts this show together. And thank you for tuning into Investing Insights. I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.

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