Retirees: What to Do With RMDs You Don't Need

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I recently visited Vanguard's headquarters as part of the annual Bogleheads event in Philadelphia. While I was there, I chatted with retirement expert Maria Bruno about what to do with required minimum distributions that you don't need.

You recently conducted some research about retirees and how they're managing their required minimum distributions. Let's talk about what you found there.

Maria Bruno: We are starting to look at IRA investor behaviors. One of the things we looked at was RMDs: How are retirees taking their distributions and what are they doing with the proceeds? And what we found was that up to 20% of Vanguard IRA investors who are taking RMDs actually reinvested them into a taxable account.

So, that was interesting in that it showed that not everyone might need their RMDs. That may not be a surprise for higher-net-worth investors or higher-income clients that we might have.

Benz: So, these are required minimum distributions that need to come out of your IRAs as well as your Traditional IRAs once you reach age 70 1/2. And you say that one of the best ways to manage those RMDs, if in fact you're lucky enough not to need your distributions in retirement, is to start thinking about that even before you are required to take those distributions. What should you be thinking about and what strategies might you be considering at that point?

Bruno: That's a good question. I think most people are inclined to think about RMDs once they start having to take them. At that point, frankly, it's too late because the IRS will mandate that you need to take these minimum distributions. So, a good time, really, to think about it is earlier. Certainly, if you are still working, if you are a near-retiree and you're looking into tax diversification, for instance, having different account types, then you may have the opportunity to direct contributions to a Roth IRA, if you don't have that. Now, Roths don't require lifetime RMDs. So, there are some tax benefits to a Roth as well.

But if you are in retirement, then what you may want to think about is managing what that tax picture might look like down the road now. And by that, what I mean is many retirees when they are newly retired or early in retirement, their income may be lower. That may be an opportunity to potentially consider Roth conversions--so, taking some distributions from the Traditional IRA and converting into a Roth. What you're doing there, yes, essentially you're paying the income taxes today, but your income tax rate may be lower. So, there may be some benefit there.

<TRANSCRIPT>

As I mentioned earlier, there are no lifetime RMDs with the Roth. And then you're also lowering your IRA balances potentially. So, you're managing those future RMDs down the road. So, a good time to think about it is before those RMDs actually kick in rather than once you're in that situation and kind of handcuffed to have to take those distributions if you don't need them.

Benz: I know in terms of conversions you've been an enthusiast about, in some cases, doing partial conversions, rather than doing a big conversion all in one go. Let's talk about why you think that can be beneficial and how retirees may use those early retirement years before they're taking RMDs to stage those conversions.

Bruno: I think there is still this notion out there that, if you have an IRA, you have to convert the whole thing, and that's not the case. You can do a series of partial conversions, and the benefit to that is you really can manage what your income tax picture looks like on a year-by-year basis. So, with a conversion, the pretax balance of the Traditional IRA that you're converting is subject to income taxation. So, that could presumably put you into a higher marginal income tax rate, and then you are paying higher taxes on that actual conversion or part of that income.

The benefit of being able to stagger this over a few years is you can manage that tax liability. Maybe you're in a year where you have a low income tax picture or income picture; that may be a year to maybe convert more. Maybe you might have some extra income in a certain year and maybe it doesn't make sense to convert that year or whatnot. But it gives you the flexibility to manage that conversion over a series of years rather than all in one shot.

Benz: You mentioned when you look at retiree behavior, a lot of them or at least a segment of them are reinvesting in taxable accounts. Are there any other avenues? Say a person has more in RMDs than they need or want to spend in a given year, is there anything else they can do with that money in addition to, or perhaps instead of, putting it into a taxable account?

Bruno: So, the IRS mandates that you have to take these distributions. What you do as a retiree with that is really up to you. You can certainly reinvest that in a taxable account. The key there is certainly to take the net proceeds; you can invest the monies into a nonretirement account. The key there is to invest tax efficiently. So, maybe municipal bond funds might make sense if you are in a high tax bracket, or broad market index funds, which are highly tax-efficient.

Those are things that you want to think about in terms of your overall asset allocation, certainly. But one of the benefits to investing tax efficiently is not only on a year-by-year basis but if you have an intent to pass those assets onto heirs, for instance, taxable accounts could benefit from the stepped-up basis. Gains would escape capital gains tax at death, for instance. So, there are some benefits there in terms of having taxable accounts, too; but the key there is to invest tax efficiently. If you're still working, for instance--you have earned income--you could potentially make a Roth IRA contribution, depending upon what that income is. So, those are probably a couple of the things there. You can certainly use it for gifting purposes or whatnot.

Benz: Maria, thank you so much. This is such an important topic. I hear so much from our readers and viewers about RMDs and, in some cases, when they're higher than they need them to be. This is really valuable information. Thanks for being here.

Bruno: Thank you.