Note: This video is one of several interviews that Morningstar director of personal finance Christine Benz had with Vanguard officials at this year's Bogleheads event. See all of the interviews here.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many affluent retirees love to hate their required minimum distributions, or RMDs. Joining me to discuss timing of required minimum distributions is Maria Bruno. Maria is head of U.S. wealth planning research at Vanguard, leading a team responsible for conducting research and analysis on a wide range of retirement wealth planning and portfolio construction topics.
Maria, thank you so much for being here.
Maria Bruno: Thank you, Christine. Good to be here with you.
Benz: Maria, you did a blog post where you talked about how a lot of people really wait until they are 70 or 70 1/2 to start thinking about required minimum distributions. You actually think that thought process should start earlier. I want to get into that, but before that let's just talk about RMDs and which account types are subject to them.
Bruno: Yes, first and foremost, these are tax-advantaged retirement accounts, either traditional 401(k)s, IRAs, individual retirement plans--those types of plans where you have made contributions throughout your working years, most likely receive a tax deduction on those contributions. The accounts grow then tax-deferred, and then later in retirement when you start taking distributions, the entire balance then would be subject to income taxes.
The one thing I will add to that is Roth 401(k)s. One of the benefits of Roth IRAs, for instance, is that you don't have to take required minimum distributions during your lifetime as the account owner. But if it's within a 401(k), you still are subjected to these required minimum distributions, but the distributions are not subject to income taxes because the dollars have already been taxed and they grow tax free. I always like to bring that up, because we sometimes forget about that one aspect of an account that could be subject to RMDs.
Benz: We're seeing more and more people take advantage of the Roth 401(k).
Bruno: Correct. We are seeing the trends increase there. One option that someone can think through is to actually roll out of the 401(k) into an IRA retirement. But, some things to think about there that go into the decision-making.
Benz: But potentially rollover that Roth 401(k) to a Roth IRA.
Bruno: Right, and then it wouldn't be subject to the mandated distributions.
Benz: Good point. Let's talk about people, who are not yet retired, maybe in their 50s and 60s, looking at their enlarged portfolio balances, thinking about retirement, wondering if it's viable. Let's talk about how they can actually start to get ahead of required minimum distributions, some ways that they can actually reduce the tax effects from required minimum distributions.
Bruno: I think it's a good place to start, but it's not an intuitive place to start. Many people are contributing to their plans; they're not thinking about what's going to happen later in retirement when I take these distributions or when I need these monies, whether or not I need to take them. The way I like to approach that is really to think about tax diversification and think about how you're directing your deferrals, whether they be into a traditional 401(k) or IRA, or whether it's a Roth vehicle if your plan sponsor allows that option within the 401(k). Many do, we're seeing increasing trends there. Then the other option, of course, would be to save outside of employer-sponsored plans and taxable accounts.
To be strategic in terms of your savings, for many individuals, traditional 401(k)s or IRAs have been the mainstream. They've been around a lot longer, were much more comfortable with those. Roth IRAs really didn't enter the marketplace until about, probably the late '90s and then they become much more prolific within 401(k)s over the last decade or so. When you think about assets, more assets are in traditional vehicles than Roth. One way to get that diversification would be to channel your deferrals into the Roth option, either within the 401(k) or an IRA, and you can split it. It doesn't have to be all or nothing.
Be mindful in terms of how you're directing those dollars. Certainly, that impacts your tax situation today because those Roth contributions are not deductible. But what you're doing is creating these different account types that will be taxed differently later in retirement.
Benz: Arguably, you could start that thought process about tax diversification even earlier in your career. If you're forward-looking, think about getting your assets perhaps in multiple account types with different tax treatment in retirement.
Bruno: Absolutely, and you know we could probably spend a good bit of time talking about Roth IRAs and 401(k)s for young investors. There's many benefits to that. But certainly as you get closer to retirement, you want to look at basically how are you allocating--we talk a lot about asset allocation but tax diversification is the same notion. You are diversifying around the direction of future tax rates. It's creating these different types of accounts that give you flexibility later in retirement.
Benz: Let's talk about someone who has already retired but isn't yet subject to required minimum distribution. So they're not yet 70 1/2. You and I have talked about this before. You've called it the retirement sweet spot. Let's talk about some opportunities that exist for people at this particular life stage.
Bruno: It's good, and I think to use the word opportunities is very strategic, because we can talk about guidelines, but how we personalize that is very individualized. The thought is, many investors during this phase, they maybe in a lower income tax bracket, maybe they are partially retired, fully retired, they may not begin taking Social Security. Their tax rate may be relatively lower. It may seem intuitive, but here is actually a good time to actually think about accelerating income to create that tax diversification. You could really do it in one of two ways. One is you can take distributions from these traditional deferred vehicles ...
Benz: So, start taking them before you're required to.
Bruno: Yeah, absolutely. They would be subject to income taxes. Pre-59 1/2, you may be subject to penalties as well. But if you're retired in that zone then if you need to spend from your portfolio, then maybe look to these tax-deferred vehicles. Yes, you are accelerating an income tax liability, but if you're going to be very surgical about this, you can be strategic in terms of maxing out the bracket. By that, I mean, there are different thresholds for tax brackets, and making full use of those low brackets while you can.
The other thing that individuals could consider is doing a series of partial Roth conversions. Tthat's a different way to create tax diversification, if you are entering retirement and feel you don't have that. Basically what you are doing there is taking a withdrawal from the traditional vehicle and converting it into a Roth vehicle. You are subject to income taxes on the pre-tax balance of the account, but then the account would grow tax free.
Benz: One reason you look at this sort of pre-RMD, post-retirement period is that in that maybe five-year window, or whatever it might be, the retiree has a little more latitude to control income in those years than once those RMD start happening?
Bruno: Yes, one they become a reality at age 70 1/2 you're fairly limited as a retiree because you are subject to those distributions. We can probably talk about some strategies there, but really being proactive to manage those accounts types earlier is, for many individuals, tax-smart. But you want to be thoughtful because if you either distribute too much or convert too much then you could be bumping yourself into a higher tax bracket. With a little bit of planning, though, you can manage that.
The other benefit as you are basically lowering your IRA balance or your 401(k) balance and then that results in potentially lower RMDs down the road as well.
Benz: Let's talk about the person who is 70 1/2. Those RMDs have started, it sounds like they've lost some tools in their tool kit that maybe they could have taken advantage of earlier in their lives. But let's talk about some strategy that people can add around required minimum in distribution. I know the qualified charitable distribution as a very popular maneuver among a lot of retirees I talk to. Let's start there.
Bruno: There are couple of things. One is the actual calculation itself as we've talked about is fairly simple. There is a life expectancy that the IRS provides, you calculate the RMD based upon the prior year-end balance. That designates the amount that you must take in terms of distribution; the penalty is pretty steep if you don't meet that. Taking the RMD first and foremost is important. How you do that--one, would be is if you're charitably inclined the QCD, which is a qualified Charitable distribution, basically the RMD is made payable to a qualified charity. For instance, here at Vanguard if we're the trustee of the IRA would instruct Vanguard to take the – it's actually it's up to $100,000.
Bruno: And that's per account owner. So, a married couple actually can do $100,000 each. Now granted those are probably decisions for higher net worth individuals, but there is flexibility there, and basically the distribution is made payable directly to the charity. So the account owner never really takes ownership of that RMD. The nice part about that is when you actually file your tax return, you designate it as a QCD and it doesn't factor into your adjusted gross income at all, it's basically taken off the top. So there is benefits to that from a tax standpoint because oftentimes we think about marginal tax rates, but we don't necessarily think about what that adjusted gross income triggers. By that what I mean is whether or not Social Security maybe taxable, for instance. Social Security benefits may be taxed at 0%, 50% taxable or 85% taxable depending upon different income thresholds. That could also increase the marginal rate.
The other thing to keep in mind is that Medicare Part B premiums are based upon income levels as well. So, if you're increasing your income it triggers not only the tax rate increase, but all these other hidden taxes potentially in the way of higher premiums or Social Security that's taxable.
Benz: Another thing, it sounds like that would burnish the appeal for the QCD is that you may not be itemizing your deductions any longer now that we have the new higher standard deduction. It seems like this maneuver might be even more attractive than perhaps in years past.
Bruno: That's actually a really good point, because if you take the QCD approach, it's not factored into the incomes and you can't take the offset charitable deduction. But because the deductions have increased, we're probably seeing more individuals who are taking advantage of the standard deduction and may not be able to itemize. It's kind of a win-win if you think about it from that perspective.
Benz: How about any other strategies for people for whom RMDs have already commenced? The QCD sounds like a good one. Are there any other things that they should be thinking about?
Bruno: There is always the case of how to take the RMD. I know I need to take this, but how do I take it?
Benz: How, when throughout the year, end of year that whole thing?
Bruno: Great, yes. So it's a good point. One would be from which accounts do I take it from. I always like to encourage retirees to think about it as a rebalancing opportunity. Take a look at the portfolio, pair back on areas where you may be overweight, most likely it's stocks given where we are with the stock market. Take strategically is a way to rebalance the portfolio back to its target asset allocation. So that's one strategic way.
The other would be, how do I take it. Do I need to take it one lump sum, throughout the year, and it really doesn't matter. What I would encourage individuals to do is to take a look at their spending account, really, their emergency reserves and see whether or not they would need to replenish that. Oftentimes at the end of the year or the beginning of the year is a comfortable spot or you could take it quarterly or throughout the year. It's pretty flexible in terms of how you can take that distribution.
Benz: Maria. Always great to hear your insights. Thank you so much for being here.
Bruno: Oh, thank you, Christine. I enjoyed it.
Benz: Thanks for watching. I am Christine Benz for Morningstar.com.