The Taxman Cometh: Required Minimum Distributions and Your Portfolio

Alec Rosen:
Welcome to The Adviser You Can Talk To Podcast. My name is Alec Rosen and I’m a CERTIFIED FINANCIAL PLANNER™ here at Adviser Investments, and one of my passions is talking to our clients about retirement income. I’m joined today by one of my esteemed colleagues, Dina Milne. Dina is an account executive and works with many of our firm’s clients on a daily basis.

Dina Milne:
Hi Alec.

Alec Rosen:
Hey, Dina. Today’s topic is required minimum distributions from retirement accounts. These are also known as RMDs.

Dina Milne:
Listen, you know, RMDs are a real big deal. It’s an important topic. We spend our whole lives putting money away in retirement accounts like 401(k)s, IRAs, SEP IRAs, and we get this tax benefit for doing that. They grow tax-deferred until we retire, but there comes a time when the plan turns around and the IRS requires us to take distributions and pay taxes on those distributions.

Alec Rosen:
Right. And there’s a lot to uncover in this conversation, so I propose that we divide this topic into two parts. The first part, let’s spend some time making sure that we all understand what required minimum distributions are and how they work. And then, Dina, if it’s okay with you, let’s pivot and talk about four strategies that we have used with our clients that might be helpful for our listeners as they think about ways that they might save on taxes, or how these RMDs may affect their overall financial plan. How does that sound on your end?

Dina Milne:
Great.

Alec Rosen:
One quick note before we jump in too far. Dina and I talked about this before we hopped on. There is some legislation going on in Congress right now that may change how some of the RMD rules work, so we’re going to have this conversation at a high level, certainly subject to change, and if you have questions, give us a call. We’re happy to walk through your specific situation if it would be helpful to you. So with that, Dina, help walk us through the basics of RMDs here.

Dina Milne:
Yeah. So let’s start with what they are and what it means exactly. So as I mentioned earlier, you know, you spend your whole career contributing to these retirement accounts, and when you reach the magic age of 70½, you’re now required to start drawing a minimum required amount each year per the IRS.

Alec Rosen:
Well, let’s jump a little bit deeper, right? So what’s the math here? What’s the nitty gritty that people should know from that 70½ magic number?

Dina Milne:
Well, the way it’s calculated is that the IRS will take the balance of the account on December 31 of the prior year. There is a life expectancy table that contains a factor that we use to calculate the distribution for that year, and the idea is that each year the factor gets smaller, and so the distribution gets bigger. It’s almost like the IRS is telling you, “Well, you’re living longer, you need to spend more.”

Alec Rosen:
Right. Or, “We need to take more,” I guess.

Dina Milne:
“We need to take more.”

Alec Rosen:
One or the other. Okay. Let’s pivot and talk more about taxes, because I think that’s really where many of our questions come from as it relates to RMDs. And it’s important to note that required minimum distributions are treated as taxable income. Now, why is that? Well, for the most part, most contributions to an IRA go in pre-tax, and they grow tax-free. So the IRS does want to make sure they get paid on these contributions, and the way they do that is, when they come out, they’re going to be treated as taxable income.

Dina Milne:
Right. So I think it’s important to keep in mind that this can be unpleasant. I hear a lot of clients complain about this. Nobody wants to pay taxes unnecessarily, but keep in mind that while you were working, you got this benefit of being able to put money away into these retirement accounts and not pay taxes on that money. So you’re deferring your taxes paid. You’re also growing the account tax deferred, and then the idea is that in retirement you’re going to be making less income, which means that you’re at a lower tax rate. Now, if you’re making more in retirement, that’s a different story. But for most of our clients, you’re making less, you’re paying less in taxes, and so when you’re taking the money out, you should be ideally paying less in taxes and getting a tax benefit.

Alec Rosen:
You are spot on, and you always bring a level head to these conversations. So thank you for that. Yes, right on.

Dina Milne:
You know, one thing that I’d like to note too is that it’s really important to pay attention to the amount that you’re required to take out each year. Now, while the custodians usually calculate that for you, if you have multiple IRAs and you’re trying to figure out how much you have to take out, make sure that you calculate properly, because if you don’t, the IRS will impose penalties.

Alec Rosen:
Oh, boy. And this is not our favorite topic, and you had just alluded to it. I think we’ll talk more about that in just a moment, but the short form of what you just said is that if you don’t take your full RMD or you miscalculate your RMD, there is a 50% penalty on the amount that didn’t come out. This is what’s called the excess accumulation penalty. So we just want to make sure that we’re reminding folks to take these on time and also that you’re calculating that right amount. But I will point out here, just conversation’s sake, if you did miss your RMD for a valid reason or you were short or you miscalculated, the IRS does allow you to submit a request to have that 50% penalty waived. Now, this is at their discretion, and you’ll have to pay any taxes due, but I think it’s something that you’ve seen in your line of work there, Dina.

Dina Milne:
Yeah. So a couple of examples, actually. One we’re working on right now. This client was working with another adviser and has come on board. Last year was her first year to start taking a required minimum distribution, and she did. She met all her required amount, but she had a unique kind of a profit-sharing plan that she wasn’t aware also fell under that RMD requirement, so she missed it. And we, in reviewing everything, we became aware, and we helped her basically deal with the IRS and ask for forgiveness for not having withdrawn that amount. And that forgiveness just means, “Please don’t penalize me.”

Alec Rosen:
Right.

Dina Milne:
So there’s a letter that you have to write, there’s a form that you submit, you have to correct the mistake, and you want to make sure that you convey that this will not happen again and it happened for a legitimate reason.

Alec Rosen:
She would have been in trouble without you, it sounds like. Have you seen any other mistakes like that?

Dina Milne:
Yeah. So there’s a very common one that we see, and it’s usually with clients that have multiple IRA accounts that are not necessarily at the same custodian. You have the ability to take your RMD from one of these accounts to cover all the plans, and so some people like to do that. They’ll have like a conservative IRA and use that for cashflow. You just have to be meticulous with your math, because if you’re adding up all the different RMDs, you could go wrong. And that’s what happened a few years ago with one of our clients. She didn’t add everything correctly. She was short by just a small margin, and same thing. We helped her. We worked with her CPA. We helped her write a letter. We corrected the error and she didn’t get penalized. So that was good.

Alec Rosen:
That’s why you’re the best in the business. So let’s recap here just quickly. We covered a lot in a short amount of time. So we talked a little bit about what RMDs are, when and how they’re calculated and taxed, and we also hit on some potential areas that our listeners should watch out for. Maybe before we close this section out, Dina, let’s just make sure folks know what accounts are affected here. So we’ve spent a lot of time talking about traditional IRAs, SEP IRAs, simple IRAs. You really have to take an RMD for all of those, right?

Dina Milne:
Yeah. And also don’t forget your inherited IRAs. While these are not subject to the 70½ rule, these are accounts that you might have inherited from a family member and you will be required to take an RMD from those,

Alec Rosen:
And your 401(k)s and 403(b)s too, right?

Dina Milne:
Yes. And I do want to note, because this is a question that we get quite frequently, is for people that have kept money in a 401(k), but they’re not actively participating in the plan anymore, they want to know if they can take all their distribution from an IRA account to satisfy both the 401(k) and the IRA, and that is not possible. Each one needs to satisfy its own requirements.

Alec Rosen:
Right. Right. And maybe one more asterix on these 401(k) plans is that you actually don’t need to take an RMD if you’re currently working and you’re not a 5% owner, so maybe a little bit more uniqueness around those two.

Dina Milne:
Right, so you wouldn’t, just to note, you wouldn’t have to take it from the 401(k), but if you have an IRA or another IRA like account, those you do have to take your RMD. Right?

Alec Rosen:
Well said. Right. Right. That’s right on. Okay. Roth IRAs.

Dina Milne:
Yes. That is a good question, and the answer is no. You do not have to take an RMD from a Roth IRA. The only exception is if it’s an inherited account. Remember that these accounts, they distribute tax-free, so you’re not really required to start taking money out of them until you want to.

Alec Rosen:
Okay. Well, I think we’ve covered all the basics. Let’s pivot and talk more about some of the strategies that you and I want to go through with our listeners here.

Dina Milne:
Yup.

Alec Rosen:
So four strategies we’re going to hit on. First one is my favorite. You have the ability to delay your first RMD to the following year. So we’re going to talk about that one first. We’re then going to talk about qualified charitable distributions. We see this a lot with our clients. From there, we’re going to pivot to Dina’s favorite topic, and talk more about Roth conversions, and then we’re going to close out our discussion with in kind withdrawals. Does that seem fair on your end?

Dina Milne:
That’s great.

Alec Rosen:
Okay. Let me kick us off and talk about that first-year delay. So we mentioned at the beginning of the podcast that in general, you must take your RMD no later than December 31 of each calendar year to avoid that 50% penalty. Now, the exception is, is that your first RMD, you can delay it until April 1st of the following year, and in that year you ended up taking two RMDs. So your first year and your second year.

Dina Milne:
Right.

Alec Rosen:
Now I guess the question is, if I’m on the other side of the table, why on earth would you want to do that?

Dina Milne:
Right. So again, I’m going to use an example because I think that’s the best way to illustrate this. So we had a client who retired last year. Her retirement date was December 31, 2018.

Alec Rosen:
Sure.

Dina Milne:
And so she had a full year of earned income. It also happened to be the year she turned 70½. So when we took a look at her required minimum distribution, we realized we would just be taking a lot more income and adding more income to a year where she made a lot of money. And so we looked forward to 2019 and we tried to see, “Well, if she took the 2018 required minimum distribution and then also had to take out her 2019 distribution, because you have to take out both in that one year, would that make sense?” And it ended up being less than the income that she took last year.

Alec Rosen:
Okay. She stopped working January 1, right?

Dina Milne:
Right.

Alec Rosen:
I’m with you.

Dina Milne:
So in her case it made a lot of sense. I have rarely seen it to make sense, because it just means you’re loading up two incomes in one year.

Alec Rosen:
Sure.

Dina Milne:
So take a look at your finances, take a look at where you are, when you’re turning 70½, and see where it’s going to be more tax-efficient to take it.

Alec Rosen:
Okay. I think that’s a good callout. Maybe we’ll pivot to one that we see more frequently then, and that would be the qualified charitable distribution. We call these QCDs, and essentially what that is a direct transfer of funds from your IRA to a qualified charity. And the nice thing here is QCDs can be counted towards satisfying that overall required minimum distribution amount for the year as long as certain rules are met along the way.

Dina Milne:
Yeah. So why don’t we look at some numbers that will help us understand this concept a little more. So let’s say for example that your required minimum distribution is $100,000 for the year, and you normally donate about $30,000 to charity each year on a regular basis. Now, if you were to make that donation of $30,000 directly from your IRA through a QCD, a qualified charitable distribution, then basically the remaining $70,000 from that $100,000 RMD that you just took out, that remaining $70,000 is income, and that $30,000 is sheltered from income because you gave it to charity.

Alec Rosen:
Right. It helps kind of fulfill that RMD requirement, right?

Dina Milne:
Exactly. And with the change in the tax code, charitable donations aren’t taxed as favorably when they’re given with after tax dollars. So this is a win-win situation really.

Alec Rosen:
I love it. And I think the only other thing I would add is making sure that folks know the limit on a QCD contribution is $100,000 for the entire year, and for qualified charitable distribution to count towards your current year’s RMG, just like Dina described, the funds must come out of your IRA by the RMD deadline, generally that December 31 number that we talked about earlier.

Dina Milne:
Right. And another note is also that you need to be 70½ or older to make a qualified charitable donation.

Alec Rosen:
What do you mean?

Dina Milne:
So for example, one of my clients, her half birthday was end of April this year, and she was dying to make a charitable donation from her IRA to a charity in February. And I had to tell her, “Hold on. You’re too young. You can’t do it right now. You have to wait for your half birthday.” And so she did. And basically the day after her birthday, she made that donation. So you have to be careful, that you can take your required minimum distribution whenever in the year that you turn 70½, but the charitable donations cannot happen unless you’re 70½.

Alec Rosen:
That’s a good callout. All right. Are you ready to talk about Roth conversions?

Dina Milne:
Yes. So you know, Roth conversions are a good way of reducing the size of your IRA in the years before you turn 70½. So what is it exactly? The idea of a Roth conversion is that you take out a sum of money from your IRA, you pay taxes on it, and then you convert it, you put it right back into your Roth. So you’re essentially paying taxes today and then moving it to the Roth where you’re not going to pay taxes when you withdraw it and it’s growing tax deferred. Yeah.

Alec Rosen:
You said something, and if I’m listening to this, you said, “My goal is to make my IRA smaller.” Walk me through that. Why are we trying to make our IRAs smaller?

Dina Milne:
So remember, when you reach that full retirement age, or 70½, where you have to start taking your distributions, if you have a large IRA, your distributions are going to be really large, which means your taxes are also going to be large.

Alec Rosen:
Ah, right.

Dina Milne:
And so you want to try and shrink it down a little. Again, I have an example. I feel like the examples help break it down a little. One of our clients retired at age 60. He had about $4 million in an IRA account, and he also had income set aside or savings set aside to cover the 10 years of income. So he wasn’t claiming social security, he wasn’t selling or liquidating any investments. He had a very small tax liability. So what he did over the 10 years between the age of 60 to 70 is every year he would convert $100,000 or a little over $100,000 from his IRA into his Roth. He would pay taxes on it, and basically at the end of 10 years, he’d converted over a million dollars.

Alec Rosen:
Wow.

Dina Milne:
And those are going to grow tax deferred until they need them or their beneficiaries inherit them.

Alec Rosen:
Right. And like you said at the beginning, Roth IRAs don’t have an RMD. They’re not required to come out. And maybe the other thing I would add is Roth IRAs are wonderful to receive as an inheritance as well because of the tax-free nature. So I think that’s a win-win in a big way, right?

Dina Milne:
Right. Right.

Alec Rosen:
All right. Our last topic, Dina, if we’re talking about Roth conversions, it feels like we have to talk about in-kind withdrawals.

Dina Milne:
So these are actually great when the market declines, and they’re kind of like an add-on to the Roth conversion. So this is probably, when you do have a decline in the market, this was probably the best time to do a Roth conversion, because you’re taking out a depreciated security, you’re paying less taxes on it. You’re not selling it. You’re just basically taking the security out in kind from your IRA, paying the tax on it, and then putting it into your Roth without liquidating it, and then giving it the chance to appreciate again in the Roth. So the idea is that you’re transferring shares without selling.

Alec Rosen:
Right. And why is that important? Well, I think not everyone pays transaction fees, but for those of you that do, there’s no transaction fee. You’re not buying, you’re not selling. I guess the reverse. You’re not selling and then buying, it’s in-kind like you mentioned. But I just, I do want to emphasize the point that you made there is, keep in mind that anything that you transfer out, you will have to pay taxes on as you would any RMD.

Dina Milne:
Right. I also want to note that the in-kind withdrawals can also be used if the market is down and you’re required to take an RMD. It’s not cashflow that you need. You’re basically just taking it and putting it into a taxable account, and you don’t want to sell the securities. It kind of breaks your heart to get uninvested while the market’s down. So the other option is you can take your required minimum distribution in-kind and you can just have the assets moved over to another account without selling them.

Alec Rosen:
Right. Wow. Well, we covered a lot today, Dina. So we talked all about RMDs. We talked about what and when and how to take them, as well as some of the tax consequences, and we also shared four strategies on how to do so efficiently. So my name is Alec Rosen here at Adviser Investments and I want to thank you for listening to another The Adviser You Can Talk to Podcast, and if you enjoyed this conversation, please do subscribe and review our show. You can also check us out at www.adviserinvestments.com/podcast/. Your feedback is always welcome, and if you have any questions or topics that you’d like for us to explore, please do email us at info@adviserinvestments.com.