Could Required Minimum Distributions Cause You to Overspend?

“But what about required minimum distributions? Don’t they force my hand with respect to my retirement spending?”

That’s the top question I receive when I’m out and about talking about retirement portfolio planning, including some of the safe spending rate research that Jeff Ptak, John Rekenthaler, and I have worked on.

The glib answer is that it’s a required minimum distribution, not required minimum spending. You have to pull the money out of traditional tax-deferred accounts like IRAs and 401(k)s and pay the taxes due once you hit age 73, but you don’t have to spend it. But more important, retirees can take comfort in the fact that the RMD percentages are pretty conservative. That was true even before the IRS released new RMD tables that went into effect last year, and it’s especially true now.

Recent RMD Adjustments

Beginning in 2022, the required minimum distribution tables that are used to calculate mandatory distributions were revised to incorporate longer life expectancies. (Note that the actuarial tables used to determine RMD amounts were developed before the coronavirus pandemic, so they don’t incorporate recent, COVID-related reductions in life expectancy in the United States.) In other words, required withdrawal amounts became smaller and therefore more conservative, albeit slightly, starting last year.

To calculate RMDs, the accountholder must divide their balance at the end of the previous year by a divisor, or life expectancy factor, that changes based on age/life expectancy. For example, prior to 2022, 75-year-olds using the Uniform Lifetime Table (the table that most RMD-subject investors use) would divide their balances by 22.9 to come up with their RMD amounts. But the new RMD tables use a divisor of 24.6 for 75-year-olds. Assuming a $1 million portfolio, that would translate into a $43,668 RMD for a 75-year-old prior to 2022, but $40,650 under the new tables. The longer life expectancies apply to all of the RMD tables currently in effect: the aforementioned Uniform Lifetime table, the Joint Life and Last Survivor Expectancy table (used by people whose spouses are more than 10 years younger), and the Single Life Expectancy table (used by certain beneficiaries of IRAs).

The Importance of Life Expectancy

Even with those adjustments factored in, retirees raised on the 4% guideline might feel some unease with spending in line with their RMDs. When RMDs commence at age 73, the RMD amount translates into a 3.8% withdrawal. By age 80, RMDs get close to 5.0%. By 85, RMDs equate to about 6.3% of the portfolio.

However, unless your goal is to leave substantial assets to charity or to heirs, your withdrawals should step up as the years go by and your life expectancy declines. Our recent retirement income research tested a few retirement-spending strategies that explicitly take an individual’s age into account to determine sustainable spending amounts, including an RMD-based system. Such systems did a good job of helping retirees maximize their lifetime cash flows, though they did indeed reduce the amount that was typically left over after 30 years of withdrawals.

Life Expectancy Plus

Retirees can also take some comfort in how the life expectancy factors that are used as divisors in the Uniform Lifetime Table are calculated. They assume not only the individual’s own life expectancy, but an additional cushion.

For example, for a 73-year-old just starting RMDs, the distribution period is 27 years. At age 80, the distribution period is more than 20 years. Compared with life expectancy, however, there’s a disconnect. According to life expectancy tables from the Social Security Administration, for example, the average life expectancy for a 73-year-old male was 12 years in 2020, and about 14 years for women. At age 80, the Social Security life expectancy is eight years for men and 10 years for women.

The explanation for the difference is that the Social Security figures are based on a single person’s life expectancy, whereas the Uniform Lifetime Tables are based on joint life expectancies. If an individual’s IRA is the sole retirement asset in a household, the idea is that RMDs wouldn’t cause the account to be fully depleted once the original account owner dies.

To help provide a cushion, the formula now used to determine an IRA account owner’s distribution period makes the very generous assumption that the beneficiary spouse is 10 years younger than the account owner, even though that may well not be the case. (The aforementioned Joint Life and Last Survivor Expectancy table is for account owners whose spouses are truly more than 10 years younger; the distribution periods on that table are longer still.) The net effect of this assumption, especially for single people or spouses who are close in age and have similar life expectancies, is that RMD-based withdrawals are quite conservative.

The Case for Reinvestment

Of course, for couples with big age gaps (but not big enough to warrant using the Joint Life and Last Survivor Expectancy table), being more conservative and not spending the full RMD amount is a sober strategy. It’s reasonable to reinvest a portion of RMDs as a safeguard against premature asset depletion. Similarly, retirees who have a strong motivation to leave assets to relatives or charity should also consider reinvesting, rather than spending, their RMDs.

They can put the money in a taxable brokerage account, which in turn can be invested tax-efficiently to simulate the tax-sheltered wrapper that the funds came out of. Alternatively, if they or their spouses` have earned income that’s greater than or equal to the contribution, they can invest unneeded RMDs in a Roth or traditional IRA. (I would favor a Roth in this context because you’re not putting the money back into a revolving door of RMDs; Roths don’t have them.)