6 Strategies You Need to Know for Required Minimum Distributions Part 1

Hey everybody, welcome to another edition of We're Talking Money Live. I'm Phil Clark from OmniStar Financial Group. We've got a great show today. Alongside me is my colleague and wealth advisor here at OmniStar, Dustin Hocken.

Thanks, Phil. Looking forward to being here, talking about required minimum distributions. Looking forward to talking to you.

We are looking forward to talking to you, and if you have an IRA, or if you plan on retiring one day and you've got qualified assets, you don't want to miss this show. So stay tuned, we'll be right back.

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All right everybody, welcome back. We're about to start the show: six smart strategies for required minimum distributions. So important. I think you're going to learn a lot today, so stay tuned. Dustin, this is a big subject, one that we probably talk about as much as any when it comes to client engagement.

So from an early age we're all encouraged to start saving for retirement. In fact, those with the largest nest eggs not only save, but they start young, they've saved consistently, and they stay invested even when markets experience rough patches. Now, if you're one of those who saved smartly for your retirement, tax-deferred growth has likely helped you accumulate significant assets for your non-working years. Accumulation was pretty simple. Distribution, that's a different story. On the other hand of accumulation is distribution; it often requires a different strategy.

So beginning at age 72, your qualified plan requires, this isn't a choice of anyone other than the government, it is a required distribution, it makes you take distributions each year. Until recently that age was only 70.5 years old, or 70 and a half. So with the newest tax changes it's moved up a little bit. That's a nice break, but you still need to plan for these distributions. On the surface, distributions can seem innocuous or of little of consequence, but making the best use out of your required minimum distributions, or RMDs, as we refer to them, should not be overlooked.

For example, if you don't need the distribution for living expenses, why not make some decisions that may benefit your long-range plans? Keep in mind the IRS makes the requirement, but you have some flexibility on timing and what to do with the money. For instance, you may want to give it to your heirs or charity, or simply reinvest it.

Why is this kind of planning so important? In one word: tax. Distributions from qualified accounts are generally taxed as ordinary income, although if you have made after-tax contributions to these accounts, part of the distribution may be non-taxable. Conversely, Roth IRAs, Roth 401(k)s are not subject to RMDs during your lifetime, and distributions are tax-free. So what does it take to create the required minimum distribution strategy? Everyone's needs are different, but the next six points might help you in developing a solid RMD strategy.

Great points, well said, Dustin. Thanks for taking us through that intro. So many people miss this opportunity for planning. They get to, say, 70 and a half in the former tax rules, and now they get to 72 within the new tax rules, and they're not ready. They don't have a strategy. And if we work with them, generally a strategy has been built long before they get there. But when we take on a client that's close to that age, or even in their 60s, what we find is that they really haven't done anything to plan for that. And so depending on their circumstances, it absolutely can make a difference in the outcome, meaning how much do they keep, how much goes to Uncle Sam.

So first question that we're going to cover today is: do you need the money for your living expenses? So when it comes to your required minimum distribution, one consideration, and the simplest, is to manage your cash flow. So you might want to consider having this money sent directly to a cash management or bank account, something that provides easy access to the money. Automatic distributions to a cash management or taxable brokerage account eliminates one major risk, and that is not making the RMD by the deadline of December 31st of that year. When you don't make the RMD, there is a penalty. You want to avoid an IRS penalty here. This mandatory withdrawal, they don't play games with it, Dustin.

Not making that required minimum distribution comes with a severe tax penalty. 50 of the required amount is what Uncle Sam is happy to take out of your wallet. Massive tax penalty.

So huge. 50. 50, wow.

When planning your budget, bear in mind that you'll generally owe income tax on any RMDs and other distributions from traditional retirement accounts. You can have taxes automatically withheld from your RMDs. If you elect not to do this, just make sure you do set money aside for tax time, and be careful, sometimes under-withholding can result in tax penalty. So let's just look at a few withdrawal methods to help you meet your RMD requirement.

Yeah, it's pretty simple here. There's an annual recalculation. This approach, as you know, Dustin, it generally requires annual distributions from the account, and it's based on a life expectancy. It's recalculated each year. But rules abound here, and you can imagine who will be held responsible. It's not your advisor, it's you. It's not your CPA, it's you. It's not your attorney, it's you. But working with the right advisory team can help take some of that responsibility off of the client.

Bottom line is there's more than one way to calculate this thing, and it often depends on where the money came from, what type of IRA it is, who is going to be making these distributions. There's different rules that apply here. We won't dig into that today, but let's talk about a couple that could be used, a couple ways that they could make these distributions. The first one you talked about in an earlier session, Dustin, was an income annuity.

Absolutely, and you make a good point. It depends on the financial plan, it depends on what the goals are, what the objectives are, and that really determines the distribution strategy. So the other option, or one other option, is purchasing an income annuity. The purchase of an annuity can help turn your IRA assets into a stream of income that's guaranteed for life, so this completely takes care of the RMDs. There are a number of limitations on the types of annuities that can be used to satisfy the RMDs, so just be sure to check with the tax professional. Additionally, only the amount used to purchase the annuity may satisfy your RMD requirement. If you have other IRA accounts, you will still need to meet required minimum distributions for them.

Annuities have advantages, most eliminate the need to worry about outliving your money, for one, but also they have drawbacks, such as the loss of access to your principal. So make sure you weigh the purchase of annuity carefully, and do so in the context of a broader retirement financial plan.

There are two payment options for annuities. There's a fixed payment option, which is lifetime payments, so those remain level, although you may choose to pay extra for a cost of living adjustment, or COLA, to increase payments annually and to help hedge against inflation. However, access to additional principal withdrawals is limited. You could use a qualified longevity annuity contract, or what we refer to as a QLAC, and that can defer payments on a portion of your pre-tax assets up to age 85 to help cover expenses for later on in life.

Yeah, and those are great points that you make about the annuity. One, just to back up for a minute, Dustin, the annuity payout, it is guaranteed, and it's a great way to avoid having to think about the RMD. It just satisfies it. But things can get a little more complicated if you have other IRA or qualified accounts outside that annuity. And so what a lot of people, or where a lot of folks make mistakes, is they think that the RMD from that annuity satisfies their general RMD. But with the annuity contract, and this is the only place that it works this way, it's when you have an annuity, that RMD is separate from your traditional IRA that's outside the annuity contract. You have to make calculations for both. I've seen people fall in that trap, and they thought all along that they were making their RMDs and they weren't, and so that can create some unintended consequences.

That is a blind spot, and that's one that people need to recognize. So if you have annuities, be sure that if they are IRA annuities, be sure that along with other IRA accounts you're having those calculations done on everything, so that you don't come up short, or, as you said a few minutes ago, under-withdrawal.

That's a great point. So we talked about the fixed payment option; now let's talk about the variable payment option. So a little more risk here.

A little more risk, right. Lifetime payments vary over time based on the performance of the underlying investments you choose. In some cases, additional withdrawals after purchase may be allowed.

The other question that we have for you, the other strategy that we always look at when we talk about the RMDs, is: do you plan to reinvest the money? So the first one was, will you need it, will you use it? That's the simplest. Now it's, maybe you don't need all of it, so now will you reinvest that money? We get that a lot. Clients will take the RMDs and they turn around and send a check to us, or we journal it from one account to another. So will you need it, we've answered that one. What happens if you want to reinvest it?

So this is all really, the simple answer is it's all according to your investment policy statements, your goals, time horizon, risk tolerance, financial circumstances in general. It's pretty simple, right? If you invest your RMD in a taxable account, that's one thing to keep in mind. In a taxable account, you may want to consider owning tax-efficient securities to help potentially reduce your tax liability. So these could include, amongst others, municipal bonds, municipal bond funds, so munis, what we call them. They pay income tax that is free from federal income tax, and in some cases free from state and local taxes as well. Note, some income from municipal bonds and mutual funds is subject to the federal alternative minimum tax.

Stocks that you intend to hold longer, just to give you the other side of the coin here, if you're going to hold them longer than, say, a year, and maybe they pay qualified dividends, those can be great tools if you're going to reinvest the money. Sales of appreciated stocks held more than a year, they naturally, everyone knows this, or you should, they get taxed at that lower long-term capital gain rate. So if it's not municipals, as you talked about, then you definitely want it to be long-term gains on this reinvested money. So we're trying to get as efficient as we can with the taxes. Remember, you paid tax when you took the RMD; now you want to be as careful and strategic with the reinvested money. We don't want to pay too much tax on that money, since we've already been hit pretty hard on the distribution.

So these qualified dividends, if you are fortunate enough to have those, they're taxed at that same low long-term capital gain rate, so a big benefit there. And so things that are investments such as, say, real estate investment trusts, let's talk about that for a minute. Keep in mind, if you put that into your account, this reinvested money, those are always going to be taxed as ordinary income. So anything that those REITs are paying, that's ordinary income, no matter how long you hold it.

Yep, that's a good point. And if you think about it, you're really paying tax twice, because you have to pay tax on the qualified money when it comes out, and because we didn't, or you didn't, make a strategic decision, you put it into another vehicle that you're also going to have to pay taxes off there as well. So it's very important to speak with a professional, talk to someone, making sure you're having the right strategy, or you could be giving another 20, 30, 40, 50 away, and you really didn't have to.

Yeah, that's true. Uncle Sam is happy to take anything that you're willing to give, and the only way that you avoid legally giving Uncle Sam more than their fair share is you have to plan. And if you've got the right plan in place, it means that you probably illuminated blind spots, you avoided them, planned around them, and you get a better result.

Absolutely, and that brings us to our third strategy for RMDs: do you plan to pass these assets to your heirs?

That's always the million-dollar question. What will you do with them, where do they go? And again, it depends, but this is a blind spot here, Dustin. A lot of clients, they aren't sure. Sometimes they are sure. Sometimes they want it to go to charity, sometimes they want it to go to the kids, sometimes it's combination. So a lot to consider here. Take it away.

Sure, and there's a lot of great strategies depending on what your wishes are. So if you do want to pass assets your heirs, you might want to consider converting traditional IRA assets to a Roth IRA. So doing this eliminates the need for RMDs, and distributions are not taxable. So one thing to note here is

Of course, converting your traditional IRA to a Roth IRA calls for careful planning and comparison. What we do is we actually run financial plans and we say, okay, what if we convert, what if we don't convert, what's going to be the best outcome, and we'll be able to go one way or the other without a doubt. This is consequential here. One wrong move, if whoever you hire to run these numbers for you, be sure that you're dealing with folks who have experience in this, because you don't want to make a mistake here.

Dustin, you remember a few years ago you could convert from a traditional to a Roth IRA and then you had the opportunity to undo it, so you could re-characterize that conversion. Well, we don't have that anymore. That's been gone now for a while, and I don't see that coming back. So because it's gone, you have to be extra careful. Know your numbers here, otherwise you could make a pretty costly mistake, and it's irrevocable.

Absolutely. And what you want to be looking at is the tax rate on converted IRA assets, so your current rate, and then compare that with the tax rate of your heirs and what they'll pay on those inherited assets. If you believe your heirs will be in a much lower tax bracket than yours, it may not make sense to convert. This is a very consequential decision, just like you said, so check with your financial, estate or tax advisor before making an irrevocable decision.

Yeah, it's these kinds of decisions that can sometimes make or break an estate. You do what you think is going to deliver the right result, and it's because maybe you were talking to someone who sort of created some emotion, they created a little fear, and then you pull the trigger, only to find out that this impetuous move cost you a lot of money. And so you don't want to do that. Roth IRA conversions are very, very good strategies, but they're not for everybody.

So because a Roth IRA has no RMDs, important here, folks, no required minimum distribution, that makes them pretty attractive. So during your lifetime, once you've converted, there's no RMDs. You can leave those assets in place for as long as you live with tax-free growth. That is so critical, so key here, and boy, does it change the outcome in a huge way. So once you convert, no more RMDs, doesn't matter how old you are, and the money grows tax-free for the remainder of the contract or the remainder of the investment, and that's as long as you live.

Your heirs will have to withdraw from that converted IRA. Even though it's Roth now, they will have a required minimum distribution each year after they inherit the account, but they don't have to pay tax on the distributions, which, that's going to potentially increase the value of your bequest, and that's what you want, after all.

So if you're age 72 or older, you're going to have to take RMDs first if you're thinking about making a conversion in a year that's beyond age 72.

So if you're there and now you're thinking about a Roth conversion, just keep in mind you will have a required minimum distribution in that year, and you have to make that RMD before you convert the remaining assets from that traditional IRA to the Roth IRA. Now, you can use the RMD to help pay the tax cost. It's got to come out anyway, so no harm, no foul on that one. But you don't want to take more money out of the traditional IRA to pay the tax.

So in other words, if you have to take money from your IRA to pay the taxes of the conversion, that immediately should say to you this is not a good move. It doesn't make sense to take more money that's going to create more tax to pay the tax bill on the conversion. So Roth IRAs, not generally subject to income tax. They are still subject to a state tax, so important that you plan accordingly here.

If you choose to convert that IRA to a Roth IRA, you're going to have to compute the income tax on the portion of the account assets converted. You're going to need to know that. However, this tax cost may be reduced in proportion to the extent you've made any non-deductible contributions to any IRA, even if it's not the one being converted. So lots to think about. That's what we're for. If you decide you want to go in this direction and you don't have an advisor, or you just want a second opinion, then we're certainly happy to help. So what else should we be thinking about here, Dustin?

I'm just sticking with the converting the Roth. It's really garnered a lot of attention in recent years, and for good reason. Talks in Washington are all over with tax increase plans and government access to qualified money. So this landscape has created a fervent effort by financial advisors to help IRA, or help clients convert their traditional IRAs to Roth IRAs. It's a little bit more protected right now, at least that's how it feels. However, everyone's not a good candidate, like you mentioned before. So before making a decision, consider other methods that might be more appropriate to transfer wealth to your heirs, and we're going to talk more about that later.

Hey, we've gone through three of the six strategies that we promised we were going to talk about. Now, these first three have taken us about a half hour or so, and we try to keep the shows to that length. So we're going to start to close the show now, and on our next edition there will be part two, and that'll be strategies five, or excuse me, four, five and six. So we'll do a second show. You'll see that in the next few weeks, and that show will contain the next three strategies, so you don't want to miss these.

The next three are going to get into more of our elements of wealth management. The first ones today, Dustin, did we covered things that are associated with retirement income, so that's one of our elements of wealth management. And then we're going to get into estate planning and philanthropy on the next episode with steps four, five and six.

So that's going to wrap up this edition of We're Talking Money, phase one of the six strategies for required minimum distributions. Come back and see us for phase two. You don't want to miss it. Thanks so much, Dustin.

Thank you. See you soon.

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