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Robert Schneider, CFP®, RICP®

Smart Strategies to Manage Required Minimum Distributions

In July, the nation’s oldest Baby Boomers reached age 70 ½, meaning they must start taking required minimum distributions (RMDs) from their retirement savings under IRS rules. It’s important to understand the effects of RMDs on income and taxes and to know there are strategies available to optimize your distribution choices.

A required minimum distribution (RMD) is the amount that owners of IRAs and qualified participants in defined contribution plans such as 401(k)s must withdraw from their retirement accounts. IRS rules require you to withdraw all of your retirement funds over the course of your remaining life. RMDs must begin no later than April 1 of the year after you reach age 70 ½ (although there are exceptions under certain conditions) and must continue in each subsequent year based on IRS life expectancy distribution tables for RMDs.

RMD rules apply to all employer-sponsored retirement plans such as 401(k), Roth 401(k), 403(b) and 457(b) and profit-sharing plans, as well as to traditional IRAs and IRA-based plans such as SEPs, SARSEPs and SIMPLE IRAs. Withdrawals are not required for Roth IRAs until after the death of the original owner.

A 2013 study by the Employee Benefit Research Institute (EBRI) showed that most investors leave their retirement savings untouched, letting it grow tax deferred as long as possible to provide income in retirement. So the impact of RMDs, which are considered taxable income, can be significant.

Among the survey’s findings:

  • About 22 percent of respondents who owned a traditional or Roth individual retirement account (IRA) took a withdrawal in 2013. Among those who made a withdrawal fewer than 10 percent were under age 59 ½.
  • For those 70 ½ or older, median withdrawal rates were close to the required amount although about 25 percent were higher.
  • Among those ages 70 or older, withdrawal rates over a four-year period showed that most were withdrawing at a rate likely to be able to sustain some level of post-retirement income from IRAs as the individual continued to age.

You cannot avoid RMDs but there are steps you can take to lessen their impact both before and after you are required to begin withdrawals. We encourage investors to gather information so you understand the rules and work with your trusted tax advisor to plan your strategy. Cleary Gull Advisors does not provide tax advice, though we do suggest you consider and discuss the following.

THE BASICS

Calculations

It’s extremely important to calculate your RMDs correctly and withdraw on time in order to avoid a penalty of 50% on the amount you failed to withdraw. There are many sources of information and worksheets, but it’s recommended to use the IRS worksheets for RMDs or at least compare your calculations against the IRS forms. Full information can be found in IRS Publication 590-B.

Calculations and withdrawals will vary depending on whether you are the account’s original owner, a spouse beneficiary or a non-spousal heir.

  • IRA Distributions – To calculate your distribution from an IRA, take the account balance as of December 31 of the previous year and divide that amount by the distribution period from the IRS’ life expectancy table applicable to your situation. Most individuals use Table III, which is for married owners whose spouses are not more than 10 years younger, married owners whose spouses are not sole beneficiaries and unmarried owners. Table I is used for non-spousal beneficiaries; Table II is used for owners whose spouses are more than 10 years younger and are the sole beneficiary. Here is a link to the IRS Tables.If you have multiple IRAs, you can determine the balance of each one as of December 31 of the previous year and add them together; then use the life expectancy table to calculate the total amount you must withdraw. However, once you have the total, you have discretion to tap one or spread the withdrawal among more accounts, as long as you withdraw the total required.  If you decide to withdraw more than required in a given year, you cannot then subtract the excess withdrawal from the subsequent year’s RMD. You must still perform the same annual RMD calculation.
  • 401(k) distributions – The rules for RMDs are slightly different for 401(k) plans. Although reaching age 70 ½ remains the trigger for RMDs and you will use the same IRS tables for your calculations, you are required to calculate the amount owed for each 401(k) account you have and withdraw the respective amount from each; you cannot choose which accounts to tap as you can with IRAs.Also, if you still are working, even part time, and do not own 5 percent or more of the company, you might be able to delay RMDs until the year in which you stop working. And, unlike with an IRA, you can continue to contribute to a 401(k) as long as you continue working.  Balances from retirement plans at prior employers might be eligible to roll over to avoid RMDs until your employment ends. The employer’s plan must include this provision – if it’s not an automatic provision.

Your First RMD

Once you reach age 70 1/2, you must take RMDs by December 31 each year, but IRS rules allow a grace period until April 1 of the next year for your first distribution only. However, if you choose to take advantage of the grace period, you must take a second distribution by December 31 of that year after you turn 70 ½ to make up for the delay. Be aware that taking two distributions that year could boost you into a higher tax bracket, affect how much of your Social Security benefit is taxable and possibly increase your Medicare premiums. If you are concerned about the potential financial impact, you should consider taking your distribution by December 31 or speaking with your financial advisors or accountant.

Cash Alternatives

Although most individuals take RMDs in cash, you can choose an in-kind distribution instead, which can be useful if you don’t want to break up your portfolio.  For example, if you have stocks, bonds or mutual funds you’d like to retain, you can transfer them to a taxable account as an in-kind distribution to cover your RMDs as long as the value equals the required amount. You will be taxed the same as you would be for a cash payment but you can save on transaction fees. The tax basis for the transferred assets will be their market value on the date of the transfer.

RMD Options

Investors who do not need their RMDs for living expenses can consider giving the income to heirs or to charitable organizations, or reinvest the money in a taxable account. IRS rules prohibit rolling over an RMD into another IRA; doing so would be considered an excess contribution and subject to penalties.

 Tax Withholding

Most IRA plan sponsors will withhold 10% of your RMD withdrawal to be sent to the IRS, but if you wish to block the withholding or increase the amount, notify your plan sponsor when you request your distribution. Having taxes withheld can help avoid the need for quarterly estimated tax payments. Some individuals use large withholdings at the end of the year to help cover their overall tax burden. If you live in a state that has an income tax, you’ll need to check on its withholding rules for IRA payouts. It’s best to consult a financial or tax advisor to determine the best strategy for your situation.

TIPS AND TAX STRATEGIES 

Take Distributions Early

Some advisors recommend taking distributions before age 70 ½ for investors who have relatively low taxable income early in retirement. That allows them to take full advantage of their tax bracket and also reduces the accounts’ value, resulting in lower RMDs later. It also could allow an individual to delay claiming Social Security, allowing that benefit to grow. For those born in 1943 or later, the benefit will grow approximately 7% per year from age 62 to your full retirement age (FRA). The benefit will grow at a rate of 8% per year every year you wait beyond your FRA up to age 70.

Convert to a Roth

Because Roths are funded with after-tax money, they are not subject to RMD rules. Converting traditional IRAs to Roth IRAs reduces RMDs or eliminates them entirely if you convert all of your traditional IRAs.  Other benefits are that gains are untaxed if you meet certain requirements and there are no required withdrawals during the original owner’s lifetime. Some advisors recommend starting conversions gradually in the years before reaching age 70, to prevent landing in a higher tax bracket from the conversions. 

Individuals with balances in a Roth 401(k) should consider rolling those dollars into a Roth IRA rather than leaving them in the Roth 401(k). As mentioned earlier in this article, Roth IRA balances are currently not subject to RMD rules.

Donate to Charity

Qualified Charitable Donations (QCDs) do not reduce an RMD per se, but all or part of your required amount up to $100,000, can be transferred directly from an IRA to a qualified 501c (3) organization, making such transfers tax free for individuals age 70 ½ or older.  (Transfers from 401(k)s are not eligible.) Taking the money from an IRA also reduces the individual’s base for calculating RMDs for the year of the transfer. Such donations are not deductible and other rules apply, so it’s wise to consult a tax or financial advisor.

Purchase a Longevity Annuity

Rules governing qualified longevity annuity contracts (QLACs) allow investors to fund such annuities with up to 25% (capped at $125,000) of the balance of an IRA (including SEP, SARSEP and SIMPLE), 401(k), 403(b) or 457 retirement plans. These annuities call for one-time, lump-sum or periodic premiums and allow you to delay RMDs until age 85, which could provide tax savings. And though you can delay a RMD on your QLAC, your assets in IRA’s, 4011k’s, etc. would still be subject to RMD. This strategy, which is a hedge to provide adequate income if you live beyond your life expectancy, should be considered within your overall financial plan. Your advisor can help you determine whether a QLAC is appropriate for you and help you choose a plan and a qualified insurer.

As with all financial matters, having a thorough, thoughtful plan for your retirement income as you approach age 70 will be critical to managing RMDs once they are required. It’s important to gather information in advance so you understand the requirements and your options and to work with your advisor to avoid mistakes that can lead to tax penalties.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.