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4 Ways to Reduce the Pain of Required Minimum Distributions

4 Ways to Reduce the Pain of Required Minimum Distributions

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. Affluent investors who are over age 72 love to hate their required minimum distributions. Joining me to discuss four strategies to make RMDs a little bit less of a hassle is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning.

Hi, Christine. Nice to see you.

Christine Benz: Hi, Susan. Great to see you.

Dziubinski: Let's start at the beginning with some stage setting. Why do RMDs exist, and who needs to take them?

Benz: This is a discussion I used to have with my mom every year toward the end of the year when we talked about why it was RMD time. The basic idea is that if you have tax-deferred accounts like IRAs, like 401(k)s, you've enjoyed some tax benefits as you've been accumulating assets pre-retirement. And the idea is that once you pass that age 72 mark, you need to begin taking some money out of the accounts and paying some taxes on them. So, IRAs and 401(k)s, traditional IRAs and 401(k)s, are the main accounts that are subject to RMDs but a whole host of other retirement accounts are as well. The major category of accounts that are not subject to RMDs are Roth IRAs, which is one of the key reasons why so many people are enthusiastic about accumulating assets in Roth IRAs.

Dziubinski: One common complaint about those folks who need to take RMDs is that they will be forced to take a higher withdrawal rate on their investments than they might like. What's the workaround for that?

Benz: Right. I would say this is one of the most common questions I get on any retirement topic. People carefully calibrate their withdrawal rates to ensure that they're sustainable that they don't exhaust their funds prematurely. And many retirees point out, well, as I move into retirement, as I get into my mid-70s and 80s, I'm getting above my desired withdrawal rate. This is making me uncomfortable. So, the key workaround there, if that's a concern for you, is that you can reinvest your required minimum distributions back into your investment portfolio. Where you can invest them really depends on your situation. If you have earned income or your spouse has earned income, you can put the money right back into a Roth IRA as long as you have enough earned income to cover that contribution amount. Many 72-year-olds are not working. They don't have earned income. So, the best option for them will be to reinvest in a taxable account. And the good news is that you can really invest that taxable account quite tax efficiently by holding exchange-traded funds, by holding municipal-bond funds. If you're in a high tax bracket, those are a couple of key categories that you'd want to think about in the context of that taxable account to make it nice and tax-efficient even after you've taken the RMD and reinvested it.

Dziubinski: Another common complaint, perhaps an even bigger complaint, is that RMDs will often force a higher tax bill for a retiree. And you say one idea to sort of help ease that is to do some planning before you're even taking your RMDs.

Benz: That's right. And this is something that I've talked about with various retirement experts over the years. Maria Bruno is a big enthusiast for this idea of the sweet spot of retirement planning where once you've retired but aren't yet subject to RMDs--so, for a lot of folks, this is sort of in the age 65 to 72 zone--that's a period when you can do a lot of tax planning to try to reduce the amount of RMDs that you'll eventually pay. A big tool in the toolkit there would be to consider conversions, potentially a series of conversions of those traditional IRA assets to Roth. That might be appropriate. And the Roth assets, as I've said earlier, would not be subject to RMDs. You might even accelerate withdrawals from tax-deferred accounts in those pre-RMD years with an eye toward reducing your balance that is subject to RMDs, and that can have a variety of beneficial tax effects later on once you are subject to RMDs, and assuming you're taking Social Security at that time, it can reduce the tax on your Social Security benefits as well. So, definitely take advantage of those early retirement years to help reduce the amount of RMDs that you'll eventually have to take.

Dziubinski: Christine, let's talk a little bit about qualified longevity annuity contracts and how they can be used to help reduce the amount of RMDs.

Benz: This is a great tool in the toolkit for retirees, especially those who are concerned about longevity, concerned about outliving their assets. This is a type of deferred annuity that someone could by using tax-deferred assets. And you can put up to 25% of your IRA or $135,000, whichever is less, into the qualified longevity annuity contract. But the nice thing about the product is that because it will begin paying you benefits, paying you income at some later date, often age 80 or 85, the amount that you've steered into the QLAC is not subject to required minimum distributions. So, here's a spot to get some tax help. Get some financial advice help to ensure that this makes sense in your situation. You don't want to buy a QLAC unless you have a need for it besides just reducing taxes. So, make sure that it's appropriate, but it can be something to consider, especially because many retirees are concerned about outliving their assets, and they also want to keep a lid on the taxes that they pay from their investment accounts.

Dziubinski: Christine, lastly, you say that once RMDs do commence, and you have to start taking them, charitable giving can help ease some of the pain associated with RMDs. Talk a little bit about that.

Benz: Absolutely. So, the best tool in the toolkit for retirees who are charitably inclined and are subject to RMDs or about to be subject to RMDs, is to consider using the qualified charitable distribution, which means that you take a portion of your IRA, and you steer it to the charity of your choice or charities of your choice up to $100,000. And the benefit of the QCD is that the amount that you give to charity does not count on your income tax, and it also reduces the amount of your portfolio that is subject to RMDs. And if you are subject to RMDs, it's deemed to satisfy your RMDs. So, it's a really great strategy. It will tend to beat, on a tax basis, pulling the money from the account and writing a check to charity. It's definitely something to investigate. Even if you're not a super large giver, if you're a more modest giver, definitely consider running your qualified charitable contributions through the IRA using the QCD.

Dziubinski: Well, Christine, thank you so much for these RMD strategies today. We appreciate your time.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

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