Whenever I speak with investors about the 4% rule for retirement-plan distributions, I invariably get a question about required minimum distributions, or RMDs. How, they ask, can they possibly adhere to a 4% withdrawal rate--or even lower--when their RMD amounts are well over the 4% threshold?
They have a good point. Individuals begin withdrawing less than 4% of their IRA balances in the year in which they turn 70 1/2, and that percentage quickly steps up from there. By the time someone hits 73 years old, RMDs will amount to more than 4% of the total RMD balance, and at age 85, RMDs will consume a whopping 6.8% of the retirement balance.
Those distributions are based on the life expectancy of the account holder or, if a spouse beneficiary is more than 10 years younger than the account owner, on both partners' life expectancies. Research from financial-planning circles lends some support to the notion that you can take out a greater percentage of your portfolio in your later years than earlier on, which is exactly what the RMD rules require you to do.
Nonetheless, some individuals simply don't need their full RMD amounts for living expenses; they'd rather keep the money invested so that it can compound and grow. And they'd no doubt like to keep deferring the tax bill on their IRA assets, too.
Although it's impossible to circumvent RMDs and their attendant taxes without incurring big penalties, there's nothing saying you have to spend that money, either. Instead, you can keep at least some of your distribution working on your behalf.
The following strategies can help you maximize the RMD proceeds you don't need for living expenses.
Strategy 1: Look for a Roth Opportunity If you have unused RMDs, the first avenue to investigate is whether you can steer at least a part of your unused distribution to a Roth IRA. While traditional IRAs don't allow contributions past age 70 1/2 and tax you when you withdraw your money, Roth IRAs carry no such strictures. You can contribute at any age, and your withdrawals will be tax-free provided you meet certain criteria. The hitch is that you or your spouse must have enough earned income to cover the amount of your Roth contribution--unearned income such as your IRA withdrawals, income from other investments, or Social Security benefits don't count.
Even if you can't make a direct Roth IRA contribution because of the earned-income hurdle, you might still consider converting at least a portion of your traditional IRA assets to Roth, thereby circumventing or at least reducing future RMDs. Because such a conversion can result in a substantial tax hit, as you'll owe taxes on the portion of the converted amount that consisted of deductible contributions and investment earnings, it's important to check with a tax professional before considering one. Yet conversions can be a good fit for some individuals, especially those who don't expect to need their RMD assets during their lifetimes and would like their heirs to inherit the IRA assets without owing income taxes. (Bear in mind that inherited Roth IRA assets may still be subject to the estate tax, however.)
Strategy 2: Mimic the Tax Efficiency of a Traditional IRA If you want to invest your RMDs but deploying your traditional IRA assets into a Roth is off limits or doesn't make sense for one reason or another, you'll have to move your unused RMDs into a taxable account. Yet with careful tax management, you can still largely simulate the tax-deferred nature of a traditional IRA outside of the confines of that tax-sheltered vehicle. Assuming you're investing the money for long-term growth, holding individual stocks--preferably nondividend payers--gives you maximum control over when you realize capital gains and could enable you to defer them many years into the future. But if you'd rather keep things simple and low-maintenance--a worthy goal once you've hit RMD age--broad stock-market index trackers and exchange-traded funds have also historically done a good job of keeping a lid on taxable capital gains while providing a lot of diversification in a single low-cost shot. Tax-managed mutual funds do the same. If bonds are in order, use Morningstar's tax-equivalent yield calculator to determine whether municipal bonds or taxable bonds are a better option given your state and federal tax rates.
Strategy 3: Deploy in Line With Asset-Allocation Needs RMDs typically come out of your account toward year-end, and that's also a good time to revisit your portfolio's overall asset allocation, especially because removing the RMDs from your IRA can throw your current asset mix out of whack with your targets. If you plan to reinvest your IRA distribution in a Roth IRA or taxable account, you can deploy it into the asset class(es) in which your portfolio is underweight. At the same time, bear in mind your time horizon for those RMD proceeds you'll be investing. Generally speaking, you'll want to invest IRA assets to meet near-term RMD needs in liquid assets such as cash or short-term bonds. Taxable assets would be next in the queue for withdrawal and therefore can step out somewhat on the risk spectrum, while Roth assets would generally be last in line and therefore should be the longest-term in nature. This article discusses sequencing of withdrawals.
Strategy 4: Assess an In-Kind Distribution If you're not holding cash to meet your RMDs, you may run into a situation where you'll need to sell longer-term securities to meet your distribution amount. If you'd like to maintain an economic position in those securities or you don't want the withdrawal to affect your asset allocation, your financial-services provider might be able to provide you with an in-kind distribution--meaning you take those shares out of the IRA and move them to a taxable brokerage account. Your new cost basis in the securities is the price on the day of the distribution. The hitch is that you'll owe taxes, just as you would with any other RMD, but your RMD would not have yielded any new cash. So you'll need to have the money on hand to pay the taxes that are due. This maneuver can be particularly attractive when less liquid securities are involved.
Strategy 5: Consider Charitable Giving Finally, if you're not using your RMDs and you typically make charitable contributions every year, you can donate all or part of your RMDs, up to $100,000, directly to a qualified charity. By doing so, you won't owe income tax on the amount of the donation. Ask your financial-services provider to deal directly with the charity to handle the transfer; to avoid having the RMDs count as taxable, it's important that you never take possession of the money.
This move is generally preferable to pocketing the RMDs, donating to charity, and taking a charitable deduction later on, as discussed in this article. By sending your RMDs directly to charity, you don't see the increase in adjusted gross income that generally accompanies an RMD. Lowering your AGI, in turn, makes it more likely that you'll qualify for deductions and credits, which typically hinge on AGI. Keeping your AGI down also reduces the chance you'll be affected by the Medicare surtax that went into effect earlier this year.
A version of this article appeared Feb. 7, 2013.
