"Do I have to?" If this were Jeopardy, the answer would be, "What question do clients ask most frequently when discussing required minimum distributions?"
For clients, the answer is yes, they must withdraw at least certain amounts from their retirement accounts when they reach the age specified under the tax code. Those trying to skip complying face a 50% penalty on any shortfall.
Many clients are reluctant to take any money from their IRAs and other tax-deferred retirement accounts. "As advisors," says Steve Roberts, president of CCP, a financial planning firm in Palatine, Ill., "we've spent years encouraging clients to save as much as possible in these accounts. Now we're telling them they must take money out, even if they don't need it, and pay tax on the distributions."
SOONER OR LATER
One seemingly simple issue involves deciding when to start required minimum distributions. The official required beginning date is the April 1 after the year a client reaches age 701/2. If Alice Smith was born Aug. 4, 1941, for instance, she'll turn 701/2 in 2012. Thus, her required beginning date for required minimum distributions is April 1, 2013.
However, IRS tables generally require taxpayers to start with a distribution that's based on their year-end balance before reaching 701/2. So Alice must take out more than 4% of her 2011 year-end balance by April 1, 2013, and withdraw a slightly larger percentage of her 2012 year-end balance by Dec. 31, 2013. Going forward, Alice must keep cutting deeper into her retirement accounts every year, based on the previous year's balance on Dec. 31.
If Alice continues to follow the regimen described above, she'll withdraw almost 8% of her retirement account in the year of her required beginning date. If Alice has a $1 million IRA, that could be close to $80,000 - potentially pushing her into a higher tax bracket that year. "The natural instinct of many clients is to delay the initial RMD as long as possible," Roberts says, but that might not be an ideal approach.
"Generally, if the client's income is not expected to change from year to year, we'll advise not to double up," says Roger Lusby III, managing partner at the Alpharetta, Ga., office of accounting firm Frazier & Deeter. That means Alice could start taking required minimum distributions by year-end 2012, and therefore take only one year's distribution in 2013, avoiding an unnecessarily large addition to taxable income in a single year.
When it comes to determining year-end balances for distribution purposes, there are some nuances to the requirements. "Some accounts can be aggregated and some can't," Roberts says. Each 401(k), Roth 401(k) and 457 plan will be treated individually for distribution calculations. For IRAs, the year-end balance is the sum of all money in traditional IRAs, SEP IRAs and SIMPLE IRAs. (Roth IRAs are excluded from the RMD rules.) Clients who have money in more than one 403(b) plan also can aggregate them.
"You compute the RMD separately for each IRA or each 403(b), but then you can take the total of all the IRA or 403(b) RMDs from any one or more of the IRAs or 403(b)s," says Natalie Choate, an attorney with Nutter McClennen & Fish, a Boston law firm.
"Say a 75-year-old individual has two IRAs, one with his 60-year-old wife as sole beneficiary and the other with his kids as beneficiaries. If you just treat the two IRAs as one combined account, you won't get the right RMD amount because different divisors apply to the two IRAs." The bottom line, she says, is that you should compute RMDs separately for each IRA and then withdraw the total RMD amount from whichever IRA you want.
To illustrate, if such a client has money in a 401(k) from one company and money in another 401(k) from another, the rules say he must withdraw at least the appropriate distribution from each of those accounts this year. However, if he has a total of around $500,000 scattered among six different IRAs, including SEPs, SIMPLEs and traditional IRAs with different beneficiaries, he should add up the required distributions for each account. If the total required minimum distribution for this year is $19,500, it can be taken from any IRAs, or in any combination.
"One of my clients has two traditional IRAs," Roberts recounts. "She has remarried, so she is in a blended family now. Her IRAs have different beneficiaries; one goes to one side of the family and one goes to the other side. The client wants to keep the IRA amounts equal so their investments are similar, and we always take the RMD amount from each IRA every year."
Another client has an IRA that's managed by Roberts' firm and an IRA that's self-managed. "We start by calculating the total of RMDs for both IRAs each year. Then we withdraw that amount from the one we manage," says Roberts, who explains that this approach makes it easier for his firm to handle its money management responsibilities.
The actual distribution calculation is generally made by the IRA custodian, but a client can tell the custodian how much to distribute and when. "For clients who use IRA withdrawals to help pay for normal living expenses, we usually establish an automatic monthly distribution from their IRA to their bank account," Roberts says. "This has the feel of a regular paycheck and allows for easy budgeting. For clients who are solely taking the distribution to cover their RMD, that is usually done once a year."
EARLIER THAN NECESSARY
While clients must begin distributions after age 701/2 in most cases, there's no law saying that they have to wait that long. Some clients will need to take IRA withdrawals right after retirement; once people pass age 591/2, they won't have to worry about paying the 10% early withdrawal penalty.
Does it ever make sense to take IRA withdrawals before age 701/2, even if the money is not needed? "Depending on your tax-rate assumptions and life expectancies, it's usually better to defer the distributions," Lusby says. Unless a client firmly believes that higher tax rates are inevitable, it generally pays to extend tax deferral.
Jim King, owner of J.P. King & Associates, an RIA firm in Walnut Creek, Calif., disagrees, saying there are situations where early distributions can make sense. "That could be the case if income averaging, by starting early and reducing future RMDs, results in lower pro forma tax costs for all years, including pre-RMD years," he explains.
"Of course, that requires assumptions on future tax brackets that seem particularly uncertain, given the recent tenor of proposals to raise more revenue by reducing both deductions and marginal rates," King continues. "People who've been assuming for the last several years that marginal rates in the future would inevitably have to rise to generate more revenue may be in for a surprise if the modified flat tax idea gains momentum."
Regardless of assumptions about future tax rates, current rates might dictate discretionary withdrawals. "When we do annual tax projections for clients, one goal is to maximize the use of the lowest tax brackets," says Sammy Grant, president of SG Financial Advisors in Atlanta. A married couple with $60,000 in taxable income this year, for example, might withdraw a total of $9,000 from their IRAs because the 15% bracket on joint returns rose to $69,000 for this tax year.
This technique can deliver some lightly taxed cash and trim future distributions. Moreover, such fine tuning needn't stop once distributions begin.
"If we can withdraw more than the RMD and stay in the lowest brackets, we will do so," Grant says. "In the future, the client may be in a higher bracket or tax rates could change." Clients whose distributions take them partway through the 15% or 25% tax bracket might take larger withdrawals if they can maintain the same marginal tax rate.
Grant adds that starting IRA distributions earlier than necessary may have other ramifications. "We consider the integration of the taxation of Social Security benefits with IRA distributions," he says. "IRA distributions are treated as income, so they can push someone into a situation where up to 85% of their Social Security benefits will be taxed. This can definitely be a reason to properly plan for IRA distributions, which might mean taking them before age 701/2, but after 591/2."
MORE THAN NECESSARY
Before or after the required beginning date, clients may be withdrawing money they don't really need from IRAs and other retirement accounts. Grant says the overwhelming majority of his clients in that age group only take required minimum distributions, while Lusby reports the same is true for most of his clients who've passed their required beginning date.
If clients withdraw more money than they need, what do they do with it? This year, at least, they can make qualified charitable distributions from their IRAs, although the provision expires at the end of 2011.
"About 85% of my clients who have passed age 701/2 take only RMDs," King says. "Of the 15% who take more, about half do so to take advantage of the IRA direct-to-charity provision in the tax code, and the other half use it to pay for general living expenses."
Lusby reports similar interest in charitable giving. "Dozens of our clients have satisfied their RMDs by using the direct transfer [up to $100,000] to qualified charities as part of their charitable and estate planning. We are hopeful that this provision may become a permanent part of the tax code."
Some of Lusby's clients go beyond the required minimum distribution amount in order to make the maximum $100,000 distribution to a charity from an IRA, he says. These donations don't generate tax deductions, but they also don't increase the IRA owner's gross income.
Even without a tax deduction, donating via an IRA can offer several benefits to seniors. IRA owners can avoid the income-based limits on charitable deductions, can get some tax relief if they don't itemize deductions and may qualify for more deductions or credit by reducing their adjusted gross income. Grant adds that a direct-to-charity IRA may lower the tax on Social Security benefits. "That tax is decided in part by AGI, which is calculated before a charitable contribution deduction," he says. Lower income also might help a client avoid some tax on Social Security benefits.
USING THE EXCESS
Most clients who take unneeded required minimum distributions move the money to a taxable investment account from an IRA, according to Grant. "If not for the RMD rule," he says, "they wouldn't have taken the distribution, so they usually don't go on a spending binge. We help clients decide which assets to withdraw, planning to leave the most tax-inefficient assets in the IRA." When assets are reinvested, they may go back into the same asset class reduced in the IRA to maintain the client's asset allocation.
"It's not like found money," Roberts says. "Clients might need it at some future time. Therefore, we encourage clients to use RMD money they don't need to build up a cash reserve or to reinvest in their taxable accounts."
Some clients, of course, have sufficient assets that they'll never need the withdrawn funds. "Then we talk about using the money for purposes such as gifts to family or to charity," Roberts adds. "Those are great conversations to have."
Donald Jay Korn is an editor at large of Financial Planning.