It’s hard to break a habit after 30 or 40 years, isn’t it? Well, if you’ve been contributing to an IRA, 401(k), 403(b) or TSP you’ve created a multi-decade healthy habit of saving, but when you turn 70 1/2 or older, it’s time to break that habit. Think of it as a IRA contribution cessation program, compliments of the IRS.
Required Minimum Distributions (RMDs) are mandatory upon reaching age 70 1/2. At this age, and for the rest of your life, you have to start withdrawing money from your IRAs, etc. each year and pay income tax on it. While this sounds simple on the surface, it’s actually pretty convoluted because the math (minimum amount required) changes each year and if you make a mistake IRS penalties can be as high as 50 percent.
RMD Mistake #1 – Getting it wrong or missing it altogether
The most expensive and easiest mistake for you to make at RMD time is miscalculating or neglecting your RMD. For any amount that you do not take out and pay tax on, the IRS levies one of the stiffest penalties in the internal revenue code — a 50-percent penalty.
Patrick Ayers, Founder and CEO of Virginia-based Ayers Financial who specializes in helping people 60+ with wealth and tax planning says that this 50-percent penalty “is in addition to your normal tax brackets…so, for example, if you are in the 15 percent federal and five percent state brackets, it could total 70 percent overall tax and penalty.”
To calculate your RMD, you add all of your qualified retirement accounts ending balances as of Dec. 31 of the previous year. You then find your age in the IRS uniform life table, locate the corresponding life expectancy factor, and then divide the total by the life expectancy factor. Pretty convoluted, huh? Let’s simplify the process with an example for a 73-year-old.
At 73 years old, the distribution period is 24.7, according to the IRS table. The previous year’s ending balance in all IRAs was $1,000,000. You then take the total IRA balance and divide by the distribution period and the result is $40,486, rounded up ($1,000,000 / 24.7) or 4.0486%. The $40,486 is of course added to your other sources of taxable income, which may easily push you into higher tax brackets or cause your Medicare premiums to increase.
The required minimum percent increases each year, requiring you to take larger and larger amounts out of your IRA and possibly leave less and less for your heirs. At age 85, for example, the required distribution amount is close to seven percent of your total IRAs.
The year in which you turn 70 1/2 you can actually defer your RMD until April the next year. According to Ayers, there is a problem potentially created, “by pushing this into the future, you will actually have to take out two withdrawals in one tax year. This may cause you to pay tax on your social security or possibly bump you into a higher tax bracket. So deferring rarely makes sense.”
RMD Mistake #2 - Taking it from the wrong place
Most IRA owners mistakenly believe that you have to take an RMD from each IRA account. The IRS allows for an “aggregation” of IRAs. They could care less which IRAs you take the distribution from, they just want you to withdraw at least the minimum amount. So, one rule of thumb would be to take your RMD from your best performing account or, better yet, any IRAs that have excess cash because of accumulated dividends, etc. It’s important to note that you are not required to take an RMD from your Roth IRAs as they have already been taxed (unless of course you inherited a Roth, which is a different story).
One problem that Ayers has seen is when one spouse passes away. Ayers explains, “if one spouse dies, the survivor normally receives the same amount of money, but he/she is in a more painful tax bracket because they have to file as a single filer. The survivor can easily go from the 15 percent to the 25 percent marginal tax bracket, which is almost double, so more financially robust families may want to disclaim (pass down) the deceased spouses IRA to the kids to avoid the tax hit.”
RMD Mistake #3 - Not investing more prudently
I think one of the most overlooked aspects of RMDs is how we should actually invest our portfolio since we are now forced to withdraw our money at a pretty good clip. Most retirees would be happy to live off of their interest/dividends and leave their principal to their heirs or even grow it a bit, but most investors or their advisors do not have a plan to accomplish this.
Because the RMD withdrawal rates begin at 3.65 percent at age 70 1/2 and steadily climb to four percent, five percent, and beyond, if not invested properly it can become easy to simply run out of money because you’re forced to take out such high amounts from your IRA each year. You must invest prudently if you want to meet your RMD and preserve/grow your principal. The first step is to increase your portfolio yield to at least match your RMD requirement, so if you’re taking 3.65 percent, your portfolio should be yielding at least four percent just to keep up with your mandatory distributions. In contrast most portfolios we see from other advisors and banking institutions yield only 1.4 to 1.9 percent, well below the yearly RMD needs, which puts pressure on the portfolio to perform. Many advisors are hoping they make enough (after their fees) to cover the RMD, but the problem is “hope” is a terrible investment strategy.
A smart, prudent investment strategy when you’re in your RMD years is to use a combination of steady dividend-paying stocks, a diversified selection of preferred stocks (as opposed to bonds), real estate investments, income producing private equity and fixed annuities to generate a broadly diversified income plan designed to exceed your RMD each year and provide some growth. With the right approach and the right team, it’s reasonable to expect a five to six percent yield even in this low interest rate market. Ayers concludes, “when you increase yield, you have to rely less on hope… and you don’t want your lifestyle in retirement to be dictated by how the market does.”