Blog

Aug 17, 2023

Money Talk: RMDs can be reduced but may be a good withdrawal strategy

The fact that the government eventually forces retirees to withdraw and pay taxes on the funds they have diligently saved in their traditional IRA and 401(k) accounts gives required minimum

The fact that the government eventually forces retirees to withdraw and pay taxes on the funds they have diligently saved in their traditional IRA and 401(k) accounts gives required minimum distributions (RMDs) their poor reputation. The lack of control over the amount, and the taxes, make RMDs a nuisance for many retirees and trigger their search for ways to reduce these withdrawals and the accompanying tax hit. On the bright side, retirees should know that simply taking required withdrawals each year will never force them to exhaust their traditional IRA and 401(k) balances. Rather, using an RMD approach to withdrawals will likely leave their ending IRA balance close to its starting level even after 25 years of withdrawals.

Remember that under the SECURE Act 2.0, the starting age for account owners to take RMDs is now 73. Technically, the first withdrawal can be delayed until April 1 or the year following the year age 73 is reached, but subsequent withdrawals must be completed by December 31st each year. The required amount is computed by dividing the prior year-end retirement account balance by an IRS life-expectancy factor.

Because RMDs now start later, possibly years after one has retired, there may be an opportunity to reduce future required withdrawals by using these tax-deferred accounts first when making withdrawals for living expenses. Traditional wisdom suggests that retirees should hold off on taking IRA withdrawals if they have another source of funds like a regular brokerage or savings account. Roth IRAs, if any, would then be tapped last. By doing some multi-year tax projections, a retiree can get a sense of whether future IRA withdrawals, whether required or simply needed for living expenses, will put them in a higher tax bracket. If so, spending down the IRA first to reduce these future distributions makes sense. Keep in mind that the tax rates are set to go up at the end of 2025 if Congress does nothing to make the current rates “permanent.”

The same logic holds for Roth conversions. If IRA funds are not needed for current expenses, it can be beneficial to move some annually to a Roth IRA to fill up a taxpayer’s current tax bracket. This locks in current tax rates and ensures that future growth will be tax free.

Retirees with charitable goals can reduce the tax hit on RMDs by executing Qualified Charitable Distributions (QCDs). QCDs are withdrawals sent directly from the IRA to a qualifying charity. These withdrawals satisfy RMD requirements and do not count as taxable income, so they are better than taking an IRA withdrawal and sending the money to a charity yourself. Up to $100,000 annually can be sent to charity this way by IRA owners over age 70 ½ when the withdrawal is made.

If one can manage the taxes such that RMDs do not trigger a significant jump in one’s tax bracket, using a percentage-based approach to retirement withdrawals should give retirees significant peace of mind that they will not exhaust their IRA assets. In fact, they should see withdrawals that increase a bit annually, barring a significant market decline, but never exhaust their account.

An article by Dr. Craig L. Israelsen (The Hidden Virtue of the RMD) does the math for us and suggests that the RMD approach may even provide an ideal withdrawal strategy for other types of accounts. Israelsen looked at the performance of a hypothetical retirement portfolio with a 60% allocation to stocks over 73 rolling 25-year retirement periods. For the retiree who starts RMD withdrawals at age 73 with a $1 million IRA balance, the average monthly RMD withdrawal was $9,779 and the IRA actually grew on average to an ending balance of $1.42 million. While past returns are not predictive of future results, the use of rolling 25-year periods does help capture a variety of market conditions in the analysis. While the ending balance was higher one average, there were certainly historical periods that produced a much lower ending balance. However, there must also have been hypothetical retirees who fared much better than average.

Of course, life does not always fit into a specific, pre-set withdrawal strategy. Expenses can be lumpy, and a retiree’s budget may not be flexible enough to reduce withdrawals following years of poor investment returns. With some pre-planning and an appropriate investment strategy, these factors should be manageable.

David T. Mayes is a CERTIFIED FINANCIAL PLANNERTM professional and IRS Enrolled Three Bearings Fiduciary Advisors, Inc., a fee-only advisory firm in Hampton. He can be reached at 603-926-1775 [email protected].