Benz: Top Tips for RMD Season

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many retirees over 70 1/2 wait until the back half of the year to take their required minimum distributions. I'm here today with Christine Benz, she is our director of personal finance, for some tips during this RMD season.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So let's start with what kind of accounts need to take RMDs. Where do you need to take these distributions from?

Benz: Pretty much any traditional tax-deferred account. So, at the top of the list would be traditional IRAs, 401(k)s and other company retirement plan assets, provided they are traditional, 401(k)s, 403(b)s, 457s would be subject to RMDs, SIMPLE IRAs and SEP IRAs, again traditional versions of those accounts would also be subject to RMDs.

Glaser: But Roth IRA holders can keep all of their money in that wrapper?

Benz: That's right, and heretofore that had been a big attraction of Roth IRAs. People like that idea of having at least some of their retirement kitties not subject to required minimum distributions. One thing to keep an eye on, though, is that President Obama and his 2017 fiscal year budget did have a proposal that would add RMDs to Roth accounts. Nothing has happened with that thus far, but it is something that appears to be on the radar in Washington, this idea of harmonizing the rules regarding withdrawals from Roth IRAs, putting them in line with what's currently in effect on traditional tax-deferred accounts.

Glaser: So, maybe it doesn't make sense to swap things into a Roth IRA hoping that you won't have to take those RMDs?

Benz: No. I had a conversation with financial planning guru Michael Kitces about this very topic, and his thought was that for people who are in retirement, getting close to retirement where their sole motivation for getting assets over into some sort of Roth account would be to avoid RMDs, he said that you probably need to have some other factors lining up in favor of the conversion before you initiate it if avoiding RMDs is your only goal.

Glaser: So, if you're 70 1/2, you have to take them. Is there any wiggle room about when exactly you need start distributions?

Benz: A little bit right at the outset of those RMD years. So, you are required to take RMDs by April 1 of the year following the year in which you turned 70 1/2. So, say I turned 70 1/2 in the second half of 2016, I would need to take my first RMD by April 1 of 2017. So, you do have a little bit of an ability to delay, but then continuing this example, I would need to take my RMD for 2017 as well for the 2017 tax year. So, you get a little bit of a deferral. People who are still working post age 70 1/2 and participating in some sort of a company retirement plan, as long as they are employed and their plan provider allows it, they can also defer withdrawals until they actually retire from work. So there are a few circumstances where you can hold off on those RMDs post age 70 1/2.

Glaser: For most financial deadlines it doesn't make sense to wait until the last minute, but you think deferring RMDs actually could be a good strategy.

Benz: I do, and I think this is why a lot of retirees do wait--perhaps it is a little bit of inertia--but from a tax standpoint if you're able to obtain even a few months each year extra of tax-deferred compounding, that may be a reason to hold off. And the other thing to bear in mind is that once the money starts coming out of these accounts, it's taxable at your ordinary income tax rate. The full amount is typically taxable from these accounts. So if you were making tax-advantaged contributions, you are getting some sort of a tax break on the contribution and the investment earnings piece, none of that has been taxed. So, it's all subject to your ordinary income tax rate when it comes out. That's another reason to defer as long as you possibly can because once you get into RMDs, once you get into taking withdrawals from these traditional tax-deferred accounts, that has the potential to bump up your tax rate.

Glaser: Defer, but don't ignore?

Benz: Exactly. And the key reason not to ignore is that you'll face a big penalty for missing an RMD. So not only will you owe the ordinary income tax that you would owe on any distribution from a traditional tax-deferred account, but you would also be subject to a 50% penalty on the amount that you should have taken out but didn't. So it's not something to mess around with. One point I would make, though, is if the individual can prove that they missed that RMD not intentionally, that it was just an oversight, that it was a mistake, you probably can circumvent that 50% penalty. But better to avoid the whole problem in the first place if you can.

Glaser: Now, you're not obligated to spend this money. What are some options for what to do with the distribution if you don't need it for your living expenses?

Benz: Yeah. I get this question a lot, Jeremy, from retirees who say, you know what, my RMD is stepping me up above my desired withdrawal rate from my portfolio. I might be forced to take out more than I need to. If that's the case, if you don't need the money, you can and should reinvest it in your portfolio. If you're someone who is still working post age 70 1/2 and you or your spouse have some sort of earned income, you can get that money actually into a Roth IRA, but it's a pretty small subset of people who are working post age 70 1/2. In that case, your only choice once you've taken the money out of the account in the form of an RMD is to reinvest it in a taxable account of some kind.

Glaser: And then what are some other tips that you have for RMD takers?

Benz: I'm a big believer in tying in RMD season with portfolio maintenance and management. So, I think it's a great time as you're starting to think about where will my RMDs come from for this year, it's a good time to look at your portfolio and see what are areas where, from an investment standpoint, it makes sense for me to do some peeling back. So, for a lot of investors if they have been pretty hands-off with their portfolios, it's probably going to be the U.S. equity piece of their portfolios that has outperformed other pieces of the portfolio. Within that U.S. equity piece investors are likely to have individual holdings or individual stocks that perhaps have grown beyond their target size or maybe in the case of individual stocks, the stocks have expanded beyond the investors' valuation range. Those areas are really ripe for the picking when it comes to RMDs. So I like that idea of tying in RMDs with portfolio rebalancing.

Glaser: Finally, you think that charitable-minded investors should look at the QCD?

Benz: Absolutely. So, this was a provision that Congress made permanent for retirees, and the basic idea is that with this qualified charitable distribution, the QCD, you send a portion of your RMD up to $100,000 directly to the qualified charity of your choice. And the benefit of doing that is that that income never touches your bottom line; it doesn't affect your modified adjusted gross income; and it tends to be more beneficial using that maneuver versus pulling the RMD, putting it into your account, sending it to the charity and then taking a deduction. Reducing that modified adjusted gross income, which the QCD allows you to do, is generally going to help you lower your tax bill a little bit more. So, it's something to keep in mind for charitably minded individuals. You don't need to do it all with a single charity; you can actually send it to a few different charities.

Glaser: Christine, thanks for your tips today.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.