Having too much money in retirement is a First World problem — a worry that doesn’t gain you much sympathy.
But for aggressive savers and investors who have more money in IRAs and 401(k)s than they need right away, the excess can be a headache. Many of them feel they are ordinary middle class folks, not 1-percenters. And what seems like surplus early in retirement may be vital to their finances years down the road. So proper handling of these accounts is essential.
A key problem: how to deal with the government’s requirement that you start withdrawing money after turning 70.5.
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Called the required minimum distribution, or RMD, the rule is meant to ensure the investor starts paying taxes on money in the account. It’s the bill finally coming due after years of deductions and deferrals.
The law requires that after 70.5, an investor takes a portion each year based on government life-expectancy tables. If you’re expected to live 20 more years, you’d have to withdraw 5 percent this year, based on your accounts’ value last Dec. 31, for example. The withdrawals are taxed as ordinary income.
And there’s a strong incentive to do it right: a penalty equal to half of the amount that should have been taken but wasn’t. (Note you don’t have to withdraw from a workplace (401(k) if you are still working with that company, and there are no withdrawal requirement from Roth accounts, whether IRAs or 401(k)s.)
RMDs are no problem for people who want to generate cash for living expenses. Investors can take as much as they like starting at age 59.5. But many who don’t need those funds right away would prefer to follow the standard advice to leave the accounts alone for as long as possible, to get the most from tax-deferred compounding. RMDs can upset that strategy.
But proper management can limit the damage, so here are a few things to consider:
Grace period. The first withdrawal after turning 70.5 does not have to be taken until April 1 of the next year (not April 15), while subsequent RMDs must be done by Dec. 31 of each year. This sounds like a good deal, but could push you into a higher tax bracket if you take two RMDs in the same year, as each withdrawal is added to your taxable income. So proper management means keeping abreast of your tax situation. Often, taxes can be saved by taking the first distribution during the year one turns 70.5 instead of waiting.
Timing. Though many investing experts caution against trying to match purchases and sales with the market’s ups and downs, RMDs force the issue. If you must sell part of a holding, it’s better to sell when prices are high rather than low. By taking a bigger portion of the account, a sale at a low can chew so deeply into your portfolio that it may never recover.
“Taking RMDs at the right time can impact your portfolio in a significant way,” says Ryan Kwiatkowski, director of marketing at Retirement Solutions in Naperville, Illinois. “Taking them during the massive sell-off in January and February 2016 would have negatively impacted portfolio balances versus waiting for the rally to bring the market back up to a new all-time high just a few months later.”
Marcus Crawshaw, a planner with William Allan Financial Services in Woodland Hills, California, describes a typical RMD dilemma: “If you have one IRA that is all stocks and one IRA that is all bonds, and you believe interest rates will rise and therefore negatively impact your bond holdings, you would want to sell some bonds and use that cash for the RMD.”
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Handling multiple accounts. RMDs are particularly tricky for those with more than one IRA account, as the rules allow the withdrawals to be done in any fashion one wants. So long as the correct dollar amount is taken, it can come from just one account, or be spread among the various accounts, evenly or not, as the investor prefers, and sales do not have to be evenly distributed among the various holdings in each account, either, says David Hryck, a tax lawyer with the Reed Smith firm in New York.
“If you have multiple accounts go ahead and take distributions from the ones that are performing the worst and leave the money to continue to compound in the better-performing ones,” he says.
Unfortunately, 401(k)s and IRAs cannot be lumped together for RMDs. Handle the IRAs as described above, then calculate the RMD for each 401(k) and make the withdrawal as if it were the only account you had.
Reinvesting. Having to take some money out doesn’t mean you must spend it. If it’s not needed, it can be reinvested in an ordinary taxable account. You could select the same stock, bond or fund that you’d just sold, or choose something different. Just be careful to set aside enough cash for the tax on the withdrawal.
There’s a real benefit to taxable accounts. Assets in those accounts can be passed to heirs tax-free due to rules that reset the tax basis (essentially, the original purchase price for figuring profits) on inherited assets to their value at the time of the previous owner’s death, says Damon Gonzalez, a planner with Domestique Capital in Plano, Texas.
Accounts with taxable contributions. Many investors make IRA and 40(k) contributions with after-tax money, receiving no tax deduction on contributions. It can be cheaper to make RMDs from these accounts, since money that was taxed before contributed is not taxed upon withdrawal.
“If the RMD would cause you to cross tax brackets, you could use some or all of the IRA with (after-tax contributions) to reduce taxable income and carry you back below the tax bracket,” Crawshaw says.
Using a Roth. Investors who worry about facing unwelcome RMDs can consider converting traditional IRAs and 401(k)s into Roth accounts, Gonzalez says. Conversions pay off for those who, for example, are in the 15 percent tax bracket at the time of the conversion but are likely to be in a 25 percent bracket after turning 70.5, as they would pay 15 percent on the converted amount to avoid a 25 percent tax later. The RMD itself cannot be converted to a Roth.
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“This strategy works really well for people who plan to give an inheritance to their children,” Gonzalez says. ” My clients in Texas don’t have a state income tax to pay on IRA distributions. I point out to them that they can pull a dollar out for 15 cents. If their son in California who is still working inherits the IRA, the son might have to pay around 40 cents in taxes to pull a dollar out.”
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