I recently ran into a retired Vanguard colleague, and he asked about what to do with his RMD. He’s in the enviable position of not needing his RMD in order to meet his spending needs. But, he’s not alone.
A recent installment of Vanguard’s IRA Insight series, But what if I don’t want my RMD?, suggests that as many as 20% of Vanguard investors who are taking RMDs are, in fact, taking the proceeds and investing in a taxable account. Of course, that means the majority of Vanguard’s retirees are spending their RMDs. Either way, I routinely field RMD questions, so it seems that, for many, RMDs may have an unwarranted mystique about them.
Since RMD “season” is well under way (in other words, the race is on to satisfy the RMD before the end of the year so as to avoid penalties), it’s a good time to review some basics.
Celebrate your “half-birthday” this one time … maybe. At age 70½, you must start taking RMDs. However, in the year you turn 70½, you can defer until April 1 of the following year (however, this flexibility is only a onetime perk). Of course, while deferring the RMD may seem appealing—as it allows the IRA to continue to grow tax-deferred—think carefully about the tax implications. Taking two RMDs the following year might push you into a higher marginal income tax bracket and, as a result, you could be paying a higher income tax rate on part of the RMD.
Rebalance with your RMD. So you know the RMD amount, but you’re not sure of the best way to withdraw it? Well, frankly, there’s no right or wrong way to withdraw the RMD from your IRA. You can take it as early as January 1*, as late as December 31, or any time in between. You can also take it as a lump sum or throughout the year. However, one best practice is to use the RMD as a way to rebalance your portfolio. The distribution is subject to ordinary income tax, regardless of which funds you withdraw from. Not only will you save yourself an extra rebalancing step, but you also won’t trigger potential taxes associated with rebalancing in taxable accounts.
Distributing is mandatory; spending is not. Perhaps you’re like my former colleague and don’t need the RMD for spending purposes. Unfortunately, you still need to satisfy the IRS-mandated distribution amount, and the withdrawal will trigger income taxes. Consider reinvesting the RMD proceeds in a taxable, nonretirement account, as long as you’re mindful of tax efficiency. Consider tax-efficient investments such as broad-market stock index funds/ETFs or municipal bond funds. As noted above, any rebalancing can be done to the tax-advantaged accounts as needed.
Think tax diversification. Take action before you reach age 70½. If you have primarily tax-deferred 401(k)s or IRAs and could benefit from tax diversification, consider converting some portion to Roth accounts. While you will be paying income tax on the conversion, you’ll reduce your traditional IRA balances and, consequently, lower your future RMD amounts. Plus, as an added benefit of Roth IRAs, there are no lifetime RMDs. A series of annual partial IRA conversions early in retirement (when your income may be relatively lower) can help manage the overall income tax liability resulting from conversions. Keep in mind, however, that once you turn 70½, the RMD must be satisfied and cannot be converted to a Roth.
Consider your beneficiaries. Regardless of whether or not you’re of RMD age, proper beneficiary planning is important because you may have the opportunity to stretch the distributions. During your lifetime, RMDs will be based on one of two IRS tables—either the IRS Uniform Lifetime Table or, if your spouse is the beneficiary and more than ten years younger, the Joint and Last Survivor Expectancy Table. When you die, the rules for determining RMDs for your beneficiaries will depend on a few factors. The first is whether your beneficiary is a spouse, nonspouse individual, or not an individual (i.e., estate or trust). The second consideration is whether you, as the IRA owner, die before age 70½. IRS Publication 590 is the go-to reference for all things IRA-related.
The reality is that RMDs are a fact of life for most retirees. So, whatever goal you have for your IRA proceeds, upfront planning will ensure that RMDs are not all that overwhelming and, literally, taxing.
*While it’s understandable that you may be eager to get a jump-start on RMDs, January 1 is technically a holiday, and the RMD will have to wait until the first business day of the year.
Note: Withdrawals from a Roth IRA are tax free if you are over age 591/2 and have held the account for at least five years; withdrawals taken prior to age 591/2 or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.