8 Questions for RMD Season
We're coming into the year's home stretch; do you know where your required minimum distributions are?
It's a high-class problem for a retiree: A large tax-deferred portfolio and no immediate need for spending money. But even though you would rather leave the money in its place, allowing it to compound on a tax-deferred basis for your heirs, the government won't let you take advantage of retirement-savings tax breaks forever. At some point, you are required to start pulling the money out and paying the tax collector.
Enter required minimum distributions, or RMDs--mandatory withdrawals that must commence from tax-deferred accounts such as 401(k)s and Traditional IRAs once a retiree passes age 70-1/2. (Investors in other situations, such as those who inherit IRAs, are also required to take RMDs, but for the purpose of this article, I'll focus on RMDs from one's own retirement accounts.)
For many retirees, RMDs are a non-issue; they're already taking more from their retirement accounts than the government requires them to do. But for affluent retirees who have enough cash on hand from other sources, RMDs can be a headache, saddling them with higher tax bills than they would otherwise have.
I've received many questions about RMDs over the years; what follows are some of the most common ones.
Is there any way to reduce the tax impact of RMDs?
To a large extent, RMD-related taxes are what they are: You'll pay ordinary income tax on your withdrawals from your IRAs and company retirement accounts, to the extent that those monies haven't been taxed yet. (Any money you contributed to your account that consisted of aftertax dollars will not be taxed again.)
The best way to reduce RMD-related taxes is to reduce the amount of your retirement kitty that's subject to them. That means accumulating assets in taxable and Roth accounts in addition to Traditional tax-deferred wrappers. For retirees, that ship has already sailed, but the post-working, pre-RMD years may be a good time to draw upon Traditional IRAs and 401(k)s for living expenses, to skinny down the balances that will be subject to RMDs later on. Additionally, converting Traditional IRAs to Roth can be appropriate in some situations; check with a tax advisor for guidance on whether that's a sensible maneuver for you. (This video discusses conversions after retirement in greater detail.)
Finally, retirees may have some leeway to tinker with other parts of their plans to help reduce the taxes they owe in high-RMD years--bunching deductions together in a single year to get more bang from itemized deductions, for example, or using a qualified charitable distribution to reduce RMD-related taxes.
What's a qualified charitable distribution?
A qualified charitable distribution, or QCD, is a way for retirees to steer up to $100,000 of their RMDs to a qualified charity; because retirees never put their mitts on the money, that portion of the RMD doesn't increase their modified adjusted gross income, which is a key determinant of an individual's tax bill. This article discusses the ins and outs of QCDs in greater detail. Doing a QCD will tend to be more beneficial, tax-wise, than withdrawing the money from an IRA, directing it to a charity, and deducting that amount.
Can I reinvest my RMD in an IRA?
Once you've taken an RMD, you can't put that money back into a Traditional IRA. You can, however, invest in a Roth IRA in the same year you take an RMD, provided you or your spouse have enough earned income--that is, income from working rather than portfolio or Social Security income--to cover your contribution amount. (I've met several retirees who have told me they have picked up part-time work for this very reason.) Roth IRAs don't carry RMD requirements. If that all sounds like too much of a bother, you can reinvest any RMDs you don't need in a taxable brokerage account, with an eye toward tax-efficient investments such as equity index funds and municipal bonds.
If I delayed my first RMD, when should I take the second one?
You often hear that RMDs commence once you turn age 70-1/2, but you actually have until April 1 of the year following the year in which you turn age 70-1/2 to take your first RMD. Let's say, for example, that you turned 70 in September 2015, and 70-1/2 in March 2016. You'd have until April 1, 2017--the year after the year in which you turned 70-1/2--to take your first RMD. You'd then need to take your next RMD by Dec. 31, 2017, however, so postponing the first RMD isn't always worth it, despite the usual admonishment to defer your tax bill for as long as you can.
My RMD is going to take me over my planned withdrawal amount. What should I do?
The government says you need to start taking your money out of your tax-deferred accounts post-age 70-1/2, but there's nothing saying that you have to spend it. Thus, if your planned withdrawal rate is 3% but your RMD is over 5% of your total portfolio, you need to reinvest that money. As noted above, you can reinvest the proceeds in a Roth IRA, provided you or your spouse have earned income and the contribution doesn't exceed $6,500. Or you can reinvest in a taxable account. Employing tax-efficient investments, you can actually do a pretty good job of reducing the drag of taxes on the taxable account on an ongoing basis, similar to what you had in your tax-deferred account.
I've been hearing that I can delay RMDs with a portion of my IRA if I buy a qualified longevity annuity contract. (QLAC). How does this work?
A qualified longevity annuity contract is a type of deferred income annuity. In contrast with immediate annuities, which start paying income straightaway, payouts from deferred income annuities commence at some later date, often at age 85. In 2014, the U.S. Treasury approved rules that made these annuities a viable option within 401(k)s and IRAs by waiving RMD requirements, which had previously been an impediment to their usefulness. For the annuity to dodge RMDs, the contract value cannot exceed $125,000, or 25% of the account balance, whichever is less. In addition to helping a portion of the portfolio avoid RMDs, the products also have merit from a planning standpoint, in that they provide a baseline of income later in life, when the portfolio may be at a low ebb. This article takes a closer look at the QLAC.
Do I need to pull RMDs from all of my IRA holdings?
No. To calculate your RMDs, look back to the balance for each of your accounts as of the previous year-end. To calculate the RMD that you'll take out by Dec. 31, 2016, for example, you'll find your balances as of Dec. 31, 2015. If you own three separate Traditional IRAs--one with an RMD of $4,000 at the end of 2015, one with a $1,000 RMD, and one with a $3,500 RMD--you'd need to take $8,500 in total, but it wouldn't matter which IRA you took it from. Because you can pick and choose where you pull them from, RMDs can be an effective way to help improve your portfolio's positioning, as discussed in this article.
Note that you can't combine RMDs from different account types--for example, if you have IRA assets as well as 401(k) that you're pulling from, you'd need to take separate RMDs. Nor can spouses combine RMDs, pulling from one spouse's account while leaving the other RMD-subject spouse's account alone; because the accounts are owned individually, the RMDs apply on an individual basis, too.
I've heard that I may be able to delay RMDs if I'm still working after age 70-1/2. True?
Yes and no. If you have IRA assets, you still have to take RMDs from those accounts post-age 70-1/2, even if you're working. But if you're still working and have assets in a company retirement plan, you can delay withdrawals from those accounts until April 1 of the year after you retire. The exception to this rule is for employees who own more than 5% of the company where they're working and participating in the plan; they must begin taking their RMDs at age 70-1/2.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.