5 RMD Pitfalls to Avoid

You can call them required minimum distributions (RMDs) or minimum required distributions (MRDs): The IRS seems to prefer the former, whereas some large investment houses employ the latter.

What's not open for debate, however, is that you must take these payouts annually from your Traditional IRAs and 401(k)s, and you must begin taking them by April 1 of the year following the year in which you turned age 70 1/2. The amount you need to take out is determined by your life expectancy, as outlined here. If you don't take your RMDs on time each year, you'll be on the hook not just for the income taxes due on the distribution, but also a penalty equivalent to 50% of the amount that you should have taken but didn't.

The reasoning behind RMDs--and the punitive treatment if you miss them--is that the government allows you to enjoy tax-deferred compounding on your money for only so long. At some point, preferably during your lifetime, it wants its cut.

For some retiree households, the RMD rules aren't important; they're actively tapping their IRAs or 401(k)s for living expenses, so they've already taken out more than the minimum during the year. But for retirees with other sources of income besides their IRAs and 401(k)s, RMDs can be a nuisance, giving them little control over their income and jacking up their tax bills. It's a high-class problem, to be sure. But given that taxes of various types can be among the biggest line items in many retiree budgets, it's hard to blame anyone for grumbling a little bit when RMD season rolls around.

With the Dec. 31 RMD deadline fast approaching, here are five key pitfalls to watch out for.

Pitfall 1: Taking too large an RMD if you have a younger spouse.
The process for calculating your RMDs is fairly straightforward. Find out the balance for your Traditional IRAs at the end of the previous year; in the case of RMDs for 2014, that means you'll need to find your account balance as of Dec. 31, 2013. Then, divide that amount by what the IRS calls a life-expectancy factor; use the factor that corresponds with your age on your birthday in 2014.

Single individuals, people whose spouses are within 10 years of their own age, or those who have someone other than their spouse as the sole beneficiary of their IRA will find their life-expectancy factor on the IRS' Uniform Lifetime table--Table III in IRS Publication 590. But people with younger spouses (defined as those at least 10 years younger) who are also the sole beneficiaries of their spouses' IRAs need to use a different table for calculating RMDs, and one that's more generous. They'll use the IRS' Joint Life and Last Survivor Expectancy table (Table II), finding the intersection between the account owner's age and the younger spouse's age. That results in a smaller payout than would be the case if the individual used Table III, based on the IRA owner's life expectancy alone. Based on Table III, for example, a 76-year-old would use a life-expectancy factor of 22 years. But if that 76-year-old had a 64-year-old husband, she'd use a life-expectancy factor of 23.4 years, thereby shrinking the RMD amount. The younger the spouse, the smaller the RMD.

Pitfall 2: Not delaying RMDs until year-end if also making charitable gifts.
In the past, the qualified charitable distribution (QCD) has been a valuable tool for investors aiming to reduce the tax impact of RMDs. That provision allowed charitably inclined retirees to divert all or part of their RMDs to charity, up to $100,000 per individual.

The hitch is that Congress has historically waited until the very end of the year to extended this provision; in fact, the QCD provision was just extended for 2014 on Tuesday night. That leaves charitably minded individuals who hope to take advantage of this maneuver playing a waiting game.

That said, it may be worth delaying your RMD until Congress acts each year, especially if you're planning large charitable contributions and don't need your RMDs. That's because the QCD is preferable to taking the RMD, making a charitable donation later, and deducting the contribution on your tax return. The reason is that diverting the RMD straight to charity means the distribution won't contribute to your adjusted gross income. That number affects your eligibility to take various credits and deductions, and a higher AGI also increases your susceptibility to the Medicare surtax.

Pitfall 3: Assuming you'll always be able to take advantage of extensions.
As noted above, you need to begin taking RMDs from your Traditional IRAs and 401(k)s by April 1 in the year following the year in which you turn 70 1/2. But don't let that April 1 deadline trip you up, because that's a one-time extension. In subsequent years, your RMD deadline will always be Dec. 31.

For example, let's say you turned 70 1/2 in July 2013. You'd have until April 1, 2014, to take your first RMD for the 2013 tax year. Then, your next RMD, for the 2014 tax year, would be due by Dec. 31, 2014.

Pitfall 4: Not reinvesting RMDs you don't need.
If you don't need your RMDs to cover living expenses, it may be easy to treat the distributions as mad money, especially because they fall around the holiday season. Be sure to factor in the effect of the RMDs on your planned portfolio spending rate, however. The percentage that you're initially required to take out of your IRAs and 401(k)s starts out comfortably below the 4% rate that many retirees use to guide their spending but then quickly escalates above that level. By age 85, RMDs are nearly 7% of the IRA balance. Of course, a higher spending rate isn't always unreasonable for older retirees; as an individual's time horizon shrinks, so does the risk of prematurely depleting capital.

But at a minimum, investors need to explore the connection between their RMDs and the sustainability of their spending rates, and reinvest any distributions they don't need. You can't put the money back into a Traditional IRA, but you can reinvest it in a Roth if either you or your spouse has enough earned income to cover the amount of your contribution. ("Earned" here means the money must come from work and cannot come from portfolio distributions or Social Security.) Alternatively, you can reinvest the money in a taxable account; this article explores how to invest RMDs you don't need.

Pitfall 5: Not being surgical about them.
As long as you've calculated the right amount to take out from each account type, you have broad latitude to pick and choose which specific investments you tap for RMDs. Thus, it's a great strategy to tie your RMDs in with your year-end portfolio checkup. That way, if you identify parts of your portfolio that you wanted to adjust anyway, you can use RMDs to help further those goals.

For example, you might draw your RMDs by pruning a stock that has well exceeded your price target for it, or by cutting back on a fund that's contributing to an overconcentration in a single sector. Or you can use the quick-and-dirty strategy of pruning the holding that has appreciated the most since your initial purchase. As 2014 winds down, many investors are apt to find that their portfolios' equity allocations are well above their targets. Thus, RMD season provides an opportunity to take risk out of your portfolio at the same time you're staying on the up-and-up with the IRS.