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Investing Specialists

7 Tips for RMD Season

Reducing the tax pain and improving your portfolio, too.

Complaining about required minimum distribution from 401(k)s might seem a little like grousing that the pool is too crowded in Florida during high season. It may be a nuisance, but in the scheme of things, it's a high-class problem to have. 

That's because for the majority of retiree households, RMDs are a nonissue. They're spending more than they're required to from their IRAs, so they don't need the IRS to tell them how much they must take out annually. (For better or for worse, there are no limits on the maximum you can take out of your IRAs.) 

For affluent retirees, however, RMDs can be unwelcome, shrinking the amount of assets that can enjoy tax-deferred compounding while also potentially forcing higher tax bills in the years they take the distributions. 

There's no single "RMD season," but many investors wait until year-end to take their distributions, perhaps to take advantage of a few extra months of tax-deferred compounding or perhaps because of inertia. With the deadline to take required minimum distributions fast approaching--Dec. 31--here are some tips to bear in mind. 

1) Take the right amount at the right time.
Calculating RMDs and taking them on time is a fairly straightforward matter, but there are a few wrinkles to bear in mind. The first is one that only first-time RMD-ers need to bear in mind: Even though Dec. 31 is the usual RMD deadline and age 70 1/2 is burned into every IRA holder's brain, the first RMD deadline is actually April 1 of the year following the year in which you turn 70 1/2. So, if you turned 70 1/2 this past July, you wouldn't need to take your first RMD until April 1, 2016. You'd then need to take an RMD again by Dec. 31, 2016--and by Dec. 31 in every year thereafter. 

Calculating RMDs, meanwhile, is a matter of dividing each of your RMD-subject account balances on Dec. 31 of the previous year by your life-expectancy factor. In the case of RMDs for this year, for example, you'd look back to your balance at the end of 2014. In most instances--whether you're single, your spouse is within 10 years of your own age, or you have someone other than your spouse as your sole beneficiary--you'd use the IRS' Uniform Lifetime table to calculate your RMD. But if your spouse is at least 10 years younger and also the sole beneficiary of your RMD-subject account, you'll use the IRS' Joint Life and Last Survivor Expectancy table (Table II in IRS Publication 590), finding the intersection between your age and your younger spouse's age. That results in a smaller payout than would be the case if you based your RMD on your life expectancy alone. 

It's also worth noting that you don't need to take RMDs from each and every IRA account, assuming you have multiple. As long as you take the right total from at least one of the accounts, you've met your distribution requirement. That allows you to take the RMD from the account(s) where it makes the most investment sense to do so. 

2) Let your year-end checkup drive what you sell.
That leads to my next point: Before you actually pull the trigger on your RMDs, conduct a thorough year-end portfolio review, taking stock of your asset allocation and the fundamentals of your holdings, including valuations. Holdings that look unattractive on a bottom-up basis or that are simply consuming too large a share of your portfolio should be at the top of your list when determining what to sell to meet RMDs. That can serve the dual goal of improving your portfolio and satisfying the IRS' requirements. 

3) Tie RMDs in with bucketing.
If you're using the bucket system for retirement-portfolio planning, you can tie RMDs to your buckets in a couple of ways. Because it's a good idea to refill your cash bucket (bucket one) throughout the year, you can have income distributions from your IRA holdings sent directly into your bucket one as they're paid out. (Whether you hold bucket one inside or outside of your IRA is a matter of personal preference.) Those distributions may fully or partially satisfy your RMDs. If by year-end those income distributions are insufficient to meet the RMDs, you can then sell something that makes sense to sell from an investment standpoint, based on your portfolio review (see above). 

4) Assess how they'll affect your taxes.
Even if you don't intend to take your RMD until later in the year, it's still valuable to calculate your RMD as soon as possible. That way, you can take steps to offset the tax impact--with tax-loss selling or accelerating deductions by prepaying property taxes, for example. A tax advisor should be able to help you gauge the impact of your RMDs on your tax bill and may be able to suggest steps you can take to reduce it. 

5) Consider a qualified charitable distribution.
For the charitably inclined, conducting what's called a qualified charitable distribution (QCD) can help kill three birds with one stone. By steering the IRA distribution directly to charity (rather than pulling the money out and then making a charitable contribution which is then deducted), the QCD enables the investor to fulfill the RMD, contribute to charity, and reduce his or her adjusted gross income at the same time. From a tax standpoint, reducing AGI is preferable to taking a "below-the-line" charitable deduction, because a lower AGI may qualify the taxpayer for credits and deductions. 

Trouble is, Congress typically hasn't green-lighted the QCD maneuver until the late innings of a calendar year, after many investors may have hoped to have had the whole RMD process wrapped up. But as financial-planning expert Michael Kitces points out here, there's no downside in steering distributions directly to charity anyway. If Congress gives the go-ahead for QCDs in 2015's waning days, the retiree can use the distribution to reduce AGI. But if, in a worst-case scenario, the QCD provision remains dormant, the retiree could simply deduct the donation, as with a typical charitable contribution. 

6) Reinvest amounts you don't need.
One question I frequently get is from investors who are concerned that RMDs will send them over their planned withdrawal rates. While RMDs begin comfortably below 4% at age 70 1/2, they quickly escalate well beyond that. Morningstar Investment Management's head of retirement research, David Blanchett, thinks that retirees could reasonably use the RMD tables as a starting point when determining their withdrawals, as withdrawals can reasonably increase as life expectancies decline. But for investors who are targeting lower withdrawal rates and whose IRAs are their whole retirement kitty, those ever-higher RMDs can be disconcerting. 

That said, it's important to remember that even though RMDs mean the money must come out of your tax-deferred vehicles and be taxed, there's no requirement that you spend them. You can and should plan to reinvest RMDs you don't need, either in a taxable account or in a Roth account if you or your spouse has enough earned income to cover the contribution amount. This video tackles the topic of investing unneeded RMDs.

7) Mull strategies for reducing them.
If you're in the position of having to take RMDs that you don't need, it's also worth thinking through the steps you can take to reduce them in the future. Converting traditional IRA assets to Roth, which don't entail RMDs, is a key idea on this front--though, ideally, you'd convert those traditional IRA assets in stages over several years rather than waiting until RMDs kick in. (The period after retirement and before RMDs is often cited as a "sweet spot" by planners; the investor is no longer earning a salary from a job and isn't yet on the hook for RMDs, so he or she may have more discretion to keep income down than at other life stages.) 

In this article, IRA expert Natalie Choate shares additional ideas for reducing RMDs, including rolling the money into a 401(k) plan if you're still working; 401(k) plan assets aren't subject to RMDs as long as you're still on the job. She also suggests that purchasing a qualified longevity annuity contract (QLAC) may be worthy of consideration for investors who are concerned about outliving their assets due to a very long life expectancy.