Charles Rotblut will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
The IRS requires that funds be withdrawn from nearly all retirement accounts, including traditional IRAs, 401(k) plans, and SEPs. These withdrawals are known as required minimum distributions, or simply RMDs. Once a retiree turns age 70½, the withdrawals must be made annually. (Roth IRAs are notably exempt from this rule, and a retiree has until April 1 of the year after he turns 70½ to make the first withdrawal.)
The IRS does not specify how you should free up the cash to take the withdrawal, only that you actually take the money out. This lack of specificity provides you with some flexibility to limit transaction costs. This inaugural Retired Investor column discusses portfolio strategies for handling required minimum distributions.
The first step is to determine how much you are required to withdraw on an annual basis. This is essentially an annual liability for your retirement portfolio, and it will be the cash goal you need to reach each year. (Any cash balances above this amount can be reinvested back into the portfolio for future growth.)
Your required minimum distribution is determined by dividing the dollar value of your IRA or retirement plan assets as of December 31 for the prior calendar year by a life expectancy factor. Appendix C of IRS Publication 590 (www.irs.gov/pub/irs-pdf/p590.pdf) has three tables with these factors. The precise table to use depends on the beneficiary of the account.
Once you have identified your required minimum distribution, calculate how much income your retirement account will likely generate throughout the calendar year. Factor in dividends from all of your equity holdings, including both common and preferred stock. Then determine the total sum of coupon payments from your bond holdings. Finally, factor in any fund distributions. You may not know the precise total, but you should be able to calculate a reasonable estimate.
The reason for using portfolio income first for your required distribution is that once you have purchased the retirement plan, the cash income from it is free of transaction costs. If you have previously reinvested your mutual fund distributions and enrolled in dividend reinvestment programs, consider whether you would be better served if you directly received the cash instead.
If you sell investments from your retirement account during the course of the year, consider keeping some of the cash proceeds available for the RMD. The same applies for individual bonds that mature during the calendar year. The ideas here are that you have already incurred the transaction costs for selling the equity investments and you have yet to incur any expenses for reinvesting the bond proceeds.
Since any transaction has the potential to change your portfolio’s allocation, you will need to factor in your risk tolerance and long-term goals. The sale of a stock or the maturation of a bond can free up cash, but you may need to reinvest some proceeds back into the same asset class. Similarly, a periodic review of your portfolio allocations, which you should do at least once a year, may result in the need to rebalance your portfolio. If you do need to rebalance, consider using some of the proceeds from the asset class you previously overweighted to help fund your required minimum distribution.
In both instances, your goal is to make double-duty of any retirement plan transactions.
The lifetime payments from an immediate annuity invested in an IRA satisfy the RMD requirements for the funds invested in the annuity, according to financial planner Paula Hogan. However, a retiree still needs to fulfill the RMD requirements for retirement savings invested outside of the annuity.
—Charles Rotblut, CFA, Editor, AAII Journal