Managing RMDs for Maximum Wealth

People are most prone to make expensive mistakes and miss opportunities with the IRAs when it is time to take distributions.

Required mini-mum distributions (RMDs) for those over age 70½ are a key source of lost wealth, and that is only going to get worse. The IRS in recent years concluded that RMD mistakes are a major source of lost tax revenue, so it is cracking down. The IRS receives enough information from IRA custodians to identify people who might have made RMD mistakes. The penalty for an incorrect RMD is 50% of the amount you should have distributed but didn’t.

While it’s important to meet the IRS’s requirements, that shouldn’t be your only goal. There are planning opportunities for RMDs that can reduce taxes or increase after-tax wealth. You have flexibility and choices, and you need to carefully consider them.

RMDs are required after age 70½. The first RMD is required by April 1 of the year after you turn 70½. For example, those who turn 70½ in 2014 must take the first RMD no later than April 1, 2015, but also can take that first RMD anytime in 2014.

It’s often best to take the first RMD in the year you turn 70½, because you’ll have to take the second RMD by Dec. 31 of the following year, giving you two RMDs in one year. Taking two RMDs could push you into a higher tax bracket, reduce tax breaks, and cause other problems.

In the years after you turn 70½, you must take an RMD each year by December 31.

There are no required minimum distributions for original owners of Roth IRAs. You also have to take RMDs from traditional employer plans, but the rules are a bit different. In this visit, we focus only on RMDs from traditional IRAs.

To compute your RMDs start with the ending value of the IRA on Dec. 31 of the previous year. When you turn 70½ in 2014, you use the closing value for 2013, even if you wait until early 2015 to take that first RMD. In years after you turn 70½, you use the IRA value at the close of the previous year. Those taking regular 2014 RMDs use the IRA values on Dec. 31, 2013.

Then, find your life expectancy in the tables furnished by the IRS in Publication 590, available free on the IRS web site at www.irs.gov. We also provide the most-used table on the members’ web site at www.RetirementWatch.com under the “Extras” tab.

There are three life expectancy tables. Table I is for beneficiaries (those who’ve inherited IRAs). Table II is for married IRA owners whose spouses are both more than 10 years younger than they are and are the sole principal beneficiaries of the IRAs. Every other IRA owner uses Table III, also known as the Uniform Lifetime Table.

Divide the IRA balance at the end of last year by your life expectancy for this year. If you turn 74 in 2014, your life expectancy under Table III is 23.8. If your IRA balance last Dec. 31 was $150,000, your RMD for 2014 is $6,303.

When you own multiple IRAs, compute the RMD by aggregating the balances of all your IRAs and dividing the total by your life expectancy. Then, you have flexibility. You can take the RMD from the IRAs in any combination you want. Take it all from one IRA or take different amounts from the IRAs in any ratio you want. This allows you to use the RMD to rebalance your overall portfolio when it’s out of balance or simplify your finances by drawing down one IRA at a time.

An RMD doesn’t have to be cash. The tax law allows the distribution to be taken in property, and most IRA custodians allow noncash distributions. With most IRA custodians, the form to request the distribution allows you to designate whether you want the distribution to be in cash or in particular assets. To make a property distribution, if you don’t already have a taxable account at the custodian, most brokers and mutual fund companies simply set up a new taxable account to receive the distribution.

You want to consider a property distribution, when you want to continue owning the asset in your portfolio or don’t want to incur the costs of selling asset. RMDs often increase as people age, resulting in distributions they don’t need to meet living expenses, so they don’t want or need extra cash at that point. When you take a distribution of property, the fair market value on the date of the distribution is included in your gross income, regardless of what happens to the asset’s price the rest of the year. That value also is your tax basis in the asset.

You can take RMDs during the course of the year on any schedule you want, as long as you take distributions totaling at least the minimum amount by Dec. 31. There are different factors to consider when deciding on the timing or you RMDs.

T. Rowe Price did a study a few years ago concluding that from 1993 to 2003, an IRA owner who waited as late as possible in the year to take RMDs accumulated a bit more money over time than an owner who took RMDs at the start of the year. The study assumed the IRA owner took distributions in cash. Since stocks generally were appreciating during that time, it made sense to leave the money to appreciate in the accounts for as long as possible.

The result would have been different if the accounts were more conservatively invested or markets weren’t booming. In fact, in the Price study, the late-distributing IRA owner was far ahead of the other IRA owner through 1999. After that, the early-distributing IRA owner rapidly caught up. Only the bull market of 2003 pushed the late-distributing owner back into a clear lead. The timing also wouldn’t matter if distributions were taken in property instead of cash.

There are other factors to consider, and these generally favor taking RMDs early in the year.

Early distributions ensure the task is not forgotten or left to a last-minute rush when IRA custodians are busy and likely to make mistakes or perform tasks late. Taking the RMD early in the year also ensures there is no problem in case anything should happen to you during the year. Executors must take RMDs from the IRAs of those who passed away during the year. But many overlook this or take time to accumulate enough information to know how much they need to take. Taking RMDs early avoids these potential problems.

Don’t forget to either factor the RMD in your estimated tax payments for the year or have the custodian withhold an appropriate amount for taxes. You don’t want to be hit with an underpayment of estimated tax penalty.

Keep in mind that you always can take more than the RMD. It is the minimum amount you are required to distribute.

RW Febuary 2014.