Taking RMDs? Keep These Tips in Mind

Retired investors got a brief respite from taking required minimum distributions from their traditional IRAs and company retirement plans in 2009. The goal of that reprieve was to allow beaten-down account balances to snap back following the market downturn.

And rebound they did (provided investors had the stamina to stick it out with their hard-hit holdings). On a less happy note, required minimum distributions also came back into play in 2010, and will be a factor for anyone taking money out of an IRA or company retirement plan for the foreseeable future.

If you're currently on the hook for RMDs, here are some key tips to be aware of when managing your distributions.

Know the Rules
For starters, be aware that the RMD simply refers to the total amount you're required to take out of your retirement account in a given year. For seniors who are drawing heavily on their retirement accounts for living expenses, the concept of RMDs may be irrelevant because they're already withdrawing more than enough to meet the requirement.

Under the RMD rules, IRA owners (traditional, SEP, and SIMPLE) and those with company retirement-plan assets (401(k), 403(b), and 457 plans) must begin taking minimum distributions by April 1 of the year following the year in which they turn age 70 1/2. They must then continue to take distributions by Dec. 31 of each year thereafter. (I wouldn't guess that there are many seniors with substantial sums in Roth 401(k)s, but those accounts are subject to RMDs, too. Roth IRAs aren't subject to RMDs.)

 

The one exception to the RMD rule is if a person is still working at age 70 1/2 and has a retirement account at that same employer. In that case, the person doesn't have to take RMDs from that account until April 1 of the year following the year in which they actually retire.

Crunching the Numbers
Calculating your RMD amount is pretty straightforward: You look back to your IRA account balance at the end of the previous year (Dec. 31, 2010, in the case of RMDs for 2011), then divide it by a factor based on your life expectancy. The Internal Revenue Service's website includes some worksheets for calculating your RMDs, but online calculators also abound, such as this one from T. Rowe Price.

 

Note that any good online calculator should ask you to input whether your spouse is your beneficiary and if so, what his or her age is. If your spouse is 10 or more years younger than you and also the beneficiary of your account, your RMDs will be lower than if your spouse is within 10 years of your own age. The thinking behind this rule is that much older spouses shouldn't have to deplete their nest eggs when the younger spouse could be around for many more years.

Do You Have the Cash?
From a portfolio-positioning standpoint, one of the most important considerations for RMDs is to make sure you have adequate liquid assets (for example, cash or short-term bonds) in the account from which to draw. The last thing you want is for your investment providers to have to sell less-liquid holdings like stocks at what could be an inopportune time just to meet RMDs.

 

Put Them on Autopilot
Because the penalty for not taking RMDs is onerous--in addition to ordinary income taxes, you'll owe a 50% penalty on any amount you should have taken but didn't--it's a good idea to sign up for automatic RMDs through your financial providers. That way you'll definitely take your distributions on schedule. This is a great option for older seniors who aren't in the mood to manage a lot of details or for adult children who are helping elderly parents simplify their investment lives.

Getting Strategic
If you're inclined to be more strategic about RMDs, the rules actually give you a good bit of discretion over the accounts from which you take distributions.

For example, say you have multiple traditional IRAs--one with Fidelity, one with Dodge & Cox, and one with Schwab. You could go account by account and take the appropriate RMD from each. However, it's also possible to total all of those IRA balances as of year-end, find your total RMD, and withdraw that amount from just one of those accounts.

The hitch is that you can't combine RMDs from disparate retirement vehicles. So say, for example, you hold three traditional IRA accounts as well as a 401(k) from a former employer. You could combine the three IRAs for RMD purposes, as in the example above, but you couldn't add in the 401(k). Instead, you'd have to calculate and take your 401(k) distribution separately.

That flexibility allows you to be strategic about where you take the money from and enables you to link RMD time with rebalancing. Say, for example, you've compared your portfolio's current weightings with your target allocations and found that your portfolio is heavier on bonds than it should be. Assuming your bond holdings are concentrated in a single IRA account, you could meet your RMDs by tapping that account while leaving your other holdings intact. Taking your RMDs may not be enough to get your account back into whack, but it could be a good starting point.

Fitting RMDs into the rebalancing process also helps ensure that you're not paying any more taxes than needed. Yes, you'll owe at least some taxes on your RMDs, provided they come from a traditional IRA or 401(k). But you'll have to pay those taxes regardless, whereas rebalancing within your taxable accounts could entail capital-gains taxes that you didn't absolutely have to pay.

 

Reinvesting RMDs
If you don't need or want to spend your RMDs, you absolutely can continue to save and invest them, just not within the confines of a traditional IRA. (You can't make additional traditional IRA contributions once you're past age 70 1/2.) You can take your RMDs and plow them into a Roth IRA, but there's an important caveat. You must have enough earned income to cover your contribution. If you've earned enough from a job to cover the amount of your Roth IRA contribution, you're in the clear. But if your only income comes from investments, you can't make a Roth contribution.

What If You Forget?
As I noted earlier, seniors who should've taken a distribution but didn't will owe the IRS an excise tax amounting to 50% of that amount--one of the most punitive levies in the whole tax code. The IRS' website says that tax will be waived if "the shortfall in distributions was due to reasonable error and that reasonable steps are being taken to remedy the shortfall." So if you've missed a distribution or didn't take as much of an RMD as you should have, you'll need to fill out IRS form 5329. You'll also have to submit a letter detailing why you had a shortfall in your distribution and what you're doing to remedy it. (A tax professional can also help coach you through this process.)

A version of this article appeared Dec. 2, 2010.

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