As we enter December, the last month on the calendar marks the final chance to cross your financial T’s and dot your I’s. For many, this means making last-minute charitable contributions, maxing out your 401k or ensuring your health care is solidified for next year. And for those individuals in their 70’s, this means satisfying their Required Minimum Distributions (RMDs).
Boring for many, I love these year-end opportunities for financial optimization. Year-end is a great time of year for something else I love –football! With college football bowl season about to begin and NFL playoffs around the corner, the action on the field is as intense as ever. And while the on-field action is all good and dandy, I always get a kick out of the “coach speak” and endless clichés heard from coaches dancing around uncomfortable questions posed by their adversaries in the media this time of year.
Admittedly, comparing RMDs and football may be a “stretch”, but I promise this won’t be an exercise in futility. With that, let’s put our visor on, grab the clipboard, and break down everything you need to know about RMDs from the sidelines. Before we begin, it should be noted that this post will only focus on standard RMDs and will not be tackling Inherited RMDs, which have slightly different rules.
BLOCKING AND TACKLING
Understand the Basics
What coach doesn’t preach the fundamentals? For starters, RMD is the common acronym for Required Minimum Distribution, which is the government’s requirement that anyone with money saved in their tax-deferred account (e.g. 401k or IRA), take a yearly distribution starting at age 70.5. You can always withdraw more than the minimum amount, but remember all distributions qualify as income, and are taxed at the ordinary income tax rates.
When do they start?
RMDs “kickoff” at age 70.5 and the individual has until April 1st of the following year to take the first withdrawal. Going forward, every RMD must be taken annually by December 31st. Even though you can elect to take your first and second RMDs in the same year, spreading out the distributions over two years may minimize total taxes paid. You should consult with a qualified advisor to see if it makes sense for you.
How are RMDs calculated?
The RMD amount is based on your age and your year-end account balance the previous year. For determining your RMD amount, you can use the IRS’s worksheet or use one of the many online calculators (here’s Schwab’s). Though many custodians will help calculate the amount, it’s important to note that it’s the tax payers responsibility to ensure the correct amount is distributed each year.
Are there penalties?
Missing an RMD won’t lose the game for you, but it will make winning more difficult. If you don’t take your RMD on time or don’t withdraw enough, the IRS penalty may be equal to 50% of the amount not distributed. For a $1mm IRA, that could mean up to an $18k penalty for not taking your own money.
DO THE LITTLE THINGS RIGHT
Since 2002, the New England Patriots have experienced unparalleled success by winning 5 NFL championships and contending for many more. So, what’s the secret to their success? The easy answer is their celebrity quarterback or charismatic coach. But any NFL insider will tell you it’s their attention to detail. Similarly, while cliché, when it comes to RMDs, executing the small stuff can help build and maintain your wealth over time. Let’s review a few areas to optimize:
Take “In-Kind” Distributions – If your cash flow situation is such that you don’t have immediate need for the cash, consider transferring securities (e.g. stocks or mutual funds) out of your IRA into a taxable brokerage account “in-kind.” This form of hand-off will allow you to avoid transaction costs and maintain your asset allocation, while avoiding the opportunity costs that come from being out of the market.
Delay distributions until year-end – Consider this a form of “milking the play clock.” The logic here is simple, take advantage of the tax-deferred treatment as long as possible. This means taking the withdrawals in December, not January or February. This is straightforward for those that don’t need the cash to support their lifestyle. For the majority that do need the cash, this is a more complex and requires coordination between your cash flow needs and resources.
Consider a Qualified Charitable Distribution (QCD) – A QCD is a direct transfer of funds from your IRA to a qualified charity. There are some rules to be aware of but this could be a good option for the charitably inclined. Because the income distributed directly to the charity counts towards the RMD amount but is tax-free, this can be a useful way for those intending to give to charity to do so in a more efficient tax manner.
Beware, although this option is better than simply taking the RMD in cash and subsequently gifting it to charity, those with appreciated securities in their taxable accounts will most likely be better off gifting appreciated shares directly to charities or Donor Advised Funds. For those looking to optimize, this option should be reviewed annually with qualified advisors.
DEFENSIVE WINS CHAMPIONSHIPS
While most view RMDs in the same vein as death and taxes, there is opportunity to get on the offensive. After all, any good coach knows that the best defense is a good offense. For retirees, this means being proactive with their tax planning before they reach age 70. The concept is simple – pay less in taxes and reduce future RMDs by proactively withdrawing money from your IRAs at lower income tax-rates than you’ll pay on withdrawals later in life.
We’ve gone into detail before, but this can be accomplished in two steps:
REVIEW THE TAPE
At Cordant, we’re proponents of focusing your time and energy on things you can control. While we will never be confused with Tom Brady, we do feel confident in our ability to quarterback our clients to a successful retirement by focusing on the details and putting them in the best position to succeed.
If you'd like some help managing your investments in a tax-efficient manner, creating a financial plan or designing a well-diversified portfolio, get in touch.