Tips for Avoiding Costly RMD Missteps

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Retirees have until the end of the year to take their required minimum distributions, or RMDs. I'm here with Christine Benz, she is our director of personal finance, to talk about some pitfalls that you should avoid.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: Let's just start with the basic about what RMDs are, required minimum distributions, and who is subject to them.

Benz: RMDs apply to traditional tax-deferred accounts. That includes IRAs, company retirement plans, SEP and SIMPLE IRAs. Roth 401(k)s are also subject to required minimum distributions. RMDs kick in once you pass age 70 1/2. You have to start taking your money out of these accounts and paying taxes on them on a predetermined schedule. The amount of RMD that you take must revolve around your balance at the end of the year prior. For 2017, for example, retirees will look back to their account balances at the end of 2016 to determine how much they need to take out of their accounts.

Glaser: The first pitfall would be not taking RMD at all or not doing it on time?

Benz: That's absolutely right. It's important to mind the deadlines. People who turn age 70 1/2 actually have a little bit of a grace period. For your first RMD, you have to take it by April 1 in the year following the year in which you turned 70 1/2. Don't ask me why it's so complicated, but it is. And then each year thereafter you have to take it by the end of the calendar year, so Dec. 31. Even if you do take advantage of that initial grace period for your first RMD, you still have to take another RMD by Dec. 31 of that same year.

You need to mind those deadlines. The reason why you want to be so careful about those deadlines is that if you miss an RMD, you will be subject to a penalty equal to half of the amount that you should have taken, but didn't, and you will still owe ordinary income taxes on those distributions as well. It's really important to mind the deadlines and certainly, never miss an RMD. If for whatever reason due to an honest mistake, for example, that you forget to take an RMD, you can fill out a form with the IRS requesting a waiver from the penalty, but you'd rather not get bogged down in that if you can possibly avoid it.

Glaser: The second pitfall is in relation to withdrawal rates. RMD is what the government says you have to take out, but that may or may not line up with the amount of money you want to take out or need to take out of your portfolio. What kind of pitfalls could happen here?

Benz: This is really an important point. It's a question I get a lot from readers, what happens if my RMD is actually higher than the amount that I want to take out of my portfolio. Many people are operating with some sort of withdrawal rate guidelines that they are imposing upon themselves. RMDs do increase as we age.

When you first start taking RMDs, they amount to about 3.5% of your RMD-subject accounts, but by the time you are age 85, they are closer to 7%. For some people, that may be a higher level than they care to take from the portfolios. If that's the case, you've got to find a way to reinvest those assets that you are pulling out of your tax-deferred accounts into some other account type.

For most people who are post-age 70 1/2, that will mean that they will need to reinvest in a taxable account. For the smaller subset of people who are subject to RMDs who have some earned income, either their own earned income or income from a spouse--not portfolio income or Social Security income or pension income, but income from earnings--if you do have enough income to cover your contribution amount, you can actually contribute to a Roth IRA. That's another idea. The key thing to know though is that one the money comes out, once you are subject to RMDs, you can't get it back into a traditional tax-deferred account.

Glaser: The third pitfall is for those that are charitably inclined. What should you keep in mind when you are taking RMDs if you do want to give money to charity?

Benz: Anyone who is making charitable contributions in a given year who is subject to a required minimum distribution should take a look at what's called a qualified charitable distribution. That allows RMD-subject investors to take up to $100,000 of their IRAs, of their RMD amount, and deploy it straight to charity. The virtue of what's called the qualified charitable distribution versus pulling the money out of your IRA, depositing it in, say, your checking account and then writing a check to a charity and then in turn deducting that contribution on your tax return is that you are able to lower your adjusted gross income because your RMD amount never hits your taxable income. It doesn't hit your adjusted gross income.

In turn, you might qualify for credits and deductions that you otherwise would not be able to qualify for with a higher AGI. That's the virtue of looking at a QCD. You don't need to put the whole $100,000 into the QCD. You can use whatever amount you like. The key thing to know though is just have your charity work with your financial provider to conduct that transaction. Let your financial provider know what you want to do. You don't want to take a check out of the account yourself.

Glaser: Finally, RMDs can be a good opportunity to improve the quality of your portfolio. It could be a pitfall to avoid doing that.

Benz: I think it's a real missed opportunity to pull your RMDs and not take a look at, well, how can I make this work for me from a portfolio standpoint. We've been talking a lot over the past several months as the market has escalated, as equities have escalated, about the virtue of rebalancing portfolios that, for those of us who have been hands-off with our portfolios, we have seen them get a lot more aggressive. This is something that retirees should bear in mind as well.

The nice thing about RMDs is that you can use your withdrawals to correct problem spots in your portfolio. Maybe you have done your homework and determined my equity allocation is really quite high relative to where it should be, where I want it to be. You could concentrate your withdrawals on the part of your portfolio that you think needs some work. In a similar vein, maybe you have some problem holdings in your portfolio, some areas that you are just not happy with. Use your RMDs to pull from those problem accounts. I think, that that's a way to find a silver lining, because a lot of retirees love to hate their RMDs. Using RMDs to correct portfolio problem spots, I think, can be a great strategy.

Glaser: Christine, thanks for sharing these pitfalls.

Benz: Thank you, Jeremy.

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