Retirement savers of a certain age — 70½ and up — never get completely free of nagging chores. Dealing with the required minimum distribution from your tax-favored individual retirement account and 401(k) is one of those headaches — it’s so easy to put off.
But if this applies to you, you’d better not wait. The penalty for failing to take this payment by the end of the year (the deadline for most) is a devastating 50 percent of what should have been withdrawn. It could cost thousands.
And although the withdrawal can be done quite easily — maybe with just a few mouse clicks — experts advise care to assure you don’t damage your strategy for investing and spending in retirement. Fortunately, the rules haven’t changed this year, but they can be tricky.
A misunderstood transaction. “Required minimum distribution is quite often the most misunderstood subject, not only by the investor but also by financial advisors,” says Richard E. Reyes, a certified financial planner with Wealth & Business Planning Group in Maitland, Florida. “RMDs were never created to give clients income for retirement. They were created as a tax recapture for the federal government.”
The requirement, therefore, does not necessarily match the investor’s best interest, he says. But it cannot be avoided.
Required minimum distributions mean paying the piper. After allowing you to defer taxes on your traditional IRAs, simple IRAs, SEP IRAs, 401(k)s and 403(b)s for all those years, Uncle Sam demands his cut after you turn 70½.
Essentially, you take the value of each account, withdraw a percentage based on a government life-expectancy table and pay federal income tax on the withdrawal. In theory, you would draw these accounts down to zero during your remaining years, so the government will get all the tax it is owed.
A typical investor turning 70½ this year is required to withdraw 3.6 percent of the total. If all IRAs and 401(k)s added up to $100,000, the investor would take $3,600 and pay $900 in tax, assuming a 25 percent tax bracket.
This isn’t a problem for someone who is ready to start spending that money. And, of course, you can always take more than the minimum. Even if you don’t need the money, taking more than required might be worth doing if you are in a very low tax bracket this year. But if you have enough income from other sources, you might want to take as little as possible from your IRA and 401(K) to postpone taxes and allow your holdings to enjoy more tax-deferred growth. That’s what most experts recommend, though it depends on the individual’s tax situation.
There is no required minimum distribution for Roth IRAs and 401(k)s because withdrawals are tax-free. And if you work past 70½, you may be able to postpone withdrawals from your current employer’s 401(k) until you retire.
How to get started. The first step is to find the value of your traditional IRA and 401(k) as of Dec. 31, 2014. Then figure the required minimum distribution using the IRS tables.
If you turned 70½ this year, you have until next April 1 for the first withdrawal (not the April 15 tax deadline). But waiting would mean taking two withdrawals in 2016, possibly raising your income enough to kick you into a higher tax bracket, causing a bigger tax bite than if you made the first withdrawal in 2015.
Once you’ve figured how much you must withdraw, you must decide what holdings to sell. You may have several mutual funds in your 401(k), for example, or have a variety of IRA and 401(k) accounts. With IRAs, so long as you withdraw the minimum required, it doesn’t matter where it comes from — from a single holding or account or spread across the board. With a 401(k), you generally must take the required minimum distribution for each account from that account.
It’s also possible to simply transfer a holding, such as mutual fund shares, to a taxable account, a good option if you really want to keep the investment. You’ll still owe tax, but this may save some hassle and transaction costs.
Many financial advisors also recommend taking portions of the minimum distribution throughout the year so that income flows steadily. It also pays to prepare for withdrawals in future years.
“Typically, we recommend clients have some of their IRA in a safer investment vehicle to fund RMDs — so, for example, they are not forced to sell during a stock market decline because their RMD deadline is approaching,” says Bill Herf, first vice president of Ziegler Wealth Management in Scottsdale, Arizona.
To start, you could look for any holdings you really don’t want anymore, such as a mutual fund that’s too risky given your age. That would be a good candidate for a sale. Remember, though, that your tax will be based on the amount you withdraw, which counts as income, regardless of how much profit or loss you had with that investment. With required minimum distributions, you cannot minimize tax by selling losers to offset winners, as you can with taxable accounts.
The tax applies to all money that has not been taxed before. If you made contributions that were not tax-deductible at the time, that money has already been taxed and is not to be taxed again.
Remember these tips. Keep in mind that any withdrawal can throw off your asset allocation — the mix of different kinds of investments you own. It may be necessary to shift some other investments to keep on target, so your holdings become neither too risky nor too conservative. In figuring this, look at the big picture, including not just your IRA and 401(k), but any taxable accounts as well.
It may make sense to sell a portion of a big winner, because those gains may have left the portfolio over-weighted in that kind of asset, says Adam Meyers, vice president of investments with Sessa and Meyers Wealth Management in Westlake Village, California. Trimming that holding “will bring a portfolio that has deviated away from a target allocation back into line,” he says.
“Deciding which assets to sell to satisfy the RMD distribution doesn’t need to be overcomplicated,” says George Guerin, president of Guerin Financial in Denver. “Investors should follow the allocation in their total portfolio. If this allocation is 60 percent bonds and 40 percent stocks, liquidate assets to satisfy the RMD, and then rebalance so that the allocation is maintained.”
If you’re going to use your required minimum distribution for expenses, you are done. But if you don’t need the money right away, you can reinvest it in an ordinary taxable account in any way you like. The sum will be reduced by the tax bite, of course, but the rest could still enjoy many years of growth.
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What Required Minimum Distributions Mean for Investors originally appeared on usnews.com
