What Retirees Should Have on Their Radar for 2021

Christine Benz: Hi, I'm Christine Benz for Morningstar. What's changing about retirement planning for 2021? Joining me to discuss that topic is Maria Bruno. She is head of U.S. wealth planning research for Vanguard.

Maria, thank you so much for being here.

Maria Bruno: Thank you, Christine. Thanks for having me.

Benz: Let's talk about 2021. 2020 for many retirees was kind of a funny year. We didn't have required minimum distributions. That was one of the big things. So, we'll have a lot of people taking their required minimum distribution for the first time in 2021. What should those new RMD-takers know?

Bruno: Well, I think first and foremost is that the RMD age has changed. It used to be 70.5, but is now age 72. So, you don't have to take a distribution until you turn 72. In the year you turn 72, you are required to take that distribution by April 1 of the following year. So, there's a little bit of flexibility in that first year.

The other thing I would probably just reinforce is the cost of not taking the distribution is pretty significant. There is a 50% excise tax for the amount that you should have taken. So, it is very important to make sure that if you are mandated to take the distribution, and again the distributions are from traditional IRAs, 401(k)s and Roth 401(k)s, although they are not taxed, still mandated to take withdrawals on an annual basis.

Benz: Definitely mark your calendar. You have until, what, 12/31 to take those distributions, right?

Bruno: Absolutely right. They're on a calendar-year basis, except for the first year that you start taking them.

Benz: Let's talk about people who aren't yet subject to RMDs, so they're not yet 72, and they have some latitude to draw from potentially different accounts. How should they approach that question, deciding whether to go into taxable accounts or tax-deferred accounts or even Roth accounts? How should they think about sourcing the cash flows that they will need for retirement, especially in those pre-RMD years?

Bruno: Yeah, that's a great question, because I often say the time to think about RMDs is not when you are 72 now, but actually quite before and thinking about that as an asset pool. For those individuals who are withdrawing from their portfolio pre-RMD age, there's flexibility to think about: How do I minimize taxes both today and then, potentially down the road? If you do have flexibility in having taxable assets or tax-deferred or Roth assets, you can be surgical on a year-by-year basis to think about: How can I minimize both the liability this year, but then also what I might be looking at in the future down the road?

The reason I bring it up is because a lot of individuals are sitting on large deferred balances, and while there is a benefit to not touching those tax-deferred assets because you can continue to enjoy tax-deferred growth, some individuals, given the size of their IRA or 401(k), can be subject to pretty large mandated distributions, which would then pretty much come with what they call the "tax torpedo,"--you have large tax liabilities. So, potentially leading up to that age 72, you could start to withdraw from those assets. Yes, you are accelerating some tax liability but hopefully to a presumably lower rate, and you're potentially also lowering future RMDs because the size of those IRAs are smaller. My suggestion would be to put some thought into it to see whether it does make sense to actually tap those assets, or maybe even think about converting some of those assets to Roth IRAs, which are not subjected to lifetime distributions.

Benz: Potentially get some tax help here, too, especially if people aren't super-conversant in figuring this stuff out--because it gets complicated.

Bruno: It can get complicated. With flexibility, sometimes comes complication, but it really does provide some planning opportunities. It is good to be thoughtful. It's also good to think about the interrelation between portfolio withdrawals and when to claim Social Security as well. There's some interplay. It does maybe have some merit to having talked to a tax professional or a financial planner, absolutely.

Benz: But you've written about those post-retirement, pre-RMD years. You've called them the "sweet spot" because that's really where your planning opportunities are, right? You have less control once those RMDs begin.

Bruno: Exactly, because they are required distributions. So, at that point the levers that you have in your toolbox, there's not as many. Certainly, be thoughtful. In terms of your options, it doesn't necessarily mean you need to do that or should. But it may vary year-by-year as well. But just make sure you think about your options during those years, absolutely.

Benz: One looming question is whether we should expect to see big changes to the tax code given that we've had the election, we'll have the changeover in the presidential administration. What's your advice to investors about how or whether to handicap those tax law changes ahead of time? Should they be preemptive in thinking about their portfolios? How should they approach that?

Bruno: Yeah, we go through this with every change of administration when there's concern or interest that there might be changes in tax legislation. We just don't know. There are proposals that are out there. We don't know exactly what will happen or when. To make changes in your portfolio or maybe your drawdown strategies, your gifting strategies, with the uncertainty--it's good to have it in mind and maybe think about what could, but be careful about making transactions or executing on strategies that may be something that you think could happen, because the reality of it is, we don't know when it will happen or if it will be retroactive to the beginning of the year. So, for individuals who just aren't sure, maybe waiting until later in the year to see what clarity we might have around changes if they come into play and when, that could be an option as well.

But I would just be careful. Understand that we might have some changes, but to make changes today based upon what we think can happen given the uncertainty around the timing of it or exactly what can happen, we don't know until it actually is legislation.

Benz: We've been talking about tax rates and withdrawals, but how about the actual withdrawal amount? Many retirees struggle with that, and of course, it's difficult to know what the right withdrawal amount is. But how's Vanguard thinking about that question? There's been a lot of debate about whether the 4% withdrawal guideline is outmoded, especially given how low yields are today. How would you urge investors to think about that?

Bruno: Yeah, I think flexibility continues to be key. No retiree really is that prescriptive in terms of what they spend every year with a very precise percentage. But when you look at what we think can happen in terms of our forecast--so Vanguard just released its economic forecast for the next decade or so. And when you look at global balanced portfolios, the return expectations are muted. You're looking at the median maybe about a 4.5% nominal return. If you consider inflation, that's probably closer to about 2.5%, 3%, and there's a wide distribution around that. So, that's lower than what we've seen in the past.

And year by year, things may change, but I think the point there is to be more realistic in terms of what to expect out of market returns and to recalibrate your spending expectations there. That doesn't mean that the 4% rule is dead or anything like that, but just be mindful in terms of what conditions we're looking at today and over the next couple of years, you might need to be a little bit mindful in terms of ratcheting back a bit. Many retirees probably do that to the extent that they can in terms of the years when market returns are higher, they might flex a little bit lower on their spending to give them more reserve in those situations where we're expecting a more muted outlook. So, I think this is a situation where over the next couple of years we might see more muted returns, maybe some volatility around that. I would recommend just being careful in terms of what you're spending and adapt to that.

Benz: Good advice as always, Maria. You're always so practical and helpful. Thank you so much for being here.

Bruno: Thank you. Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.