Strategies for Coping with RMDs

This post is for anyone who has a pretax account and is at the stage of life when you have to take RMDs (required minimum distributions).

(If this isn't you, it may be someone you know.)

First, a friendly reminder: If you haven’t already taken your RMD for 2018, you need to do so by the end of this year (December 31). If 2018 is the year you turned or will turn 70½, then if you like, you can delay your first RMD until April 1, 2019. (However, that means taking two RMDs in one year, as the deadline for your second RMD is fixed at December 31, 2019.)

As for how much your RMD will be, it depends on your circumstances. If your spouse is the sole beneficiary of the account and is more than 10 years younger than you, this worksheet will help you calculate your RMDs. Otherwise, this worksheet applies to you.

IMPORTANT NOTE: If you’ve inherited a pretax account from someone who’s deceased, you may have to start taking RMDs on it, even if they died before turning 70½, and even if you yourself aren’t yet 70½. If the deceased was your spouse, and you were the sole beneficiary of that account, then you can treat it like your own IRA and wait till you reach 70½. You can even merge that money with your own IRA if it will be to your advantage. But if the deceased wasn’t your spouse, or you weren’t the sole beneficiary, then you’ll have to keep that money separate from your own pretax accounts, you won’t be able to add to it, and you’ll have to start taking RMDs — unless the deceased wasn’t yet 70½, in which case you can give yourself up to 5 years to empty the account at your own pace. (See here for further details.) Oh, and by the way, everything I said above about an inherited pretax account also applies to an inherited Roth account. The only way you can treat an inherited Roth IRA as your own (meaning you never have to take money out from it unless and until you want to) is if you inherited it from your spouse and were the sole beneficiary of the account. Otherwise, you’ll have to take it out in accordance with the same rules as an inherited pretax account (even though the money will come to you tax-free).

As I explained in a previous post, RMDs put you between a rock and a hard place: you have to take out an ever-increasing percentage of what’s likely an ever-shrinking source of income — just so that you can give up some of that money to the IRS — or else face a penalty of 50% of what you were supposed to take out! Because of this, I warned readers against concentrating too much of their retirement money in pretax accounts. But what if you already find yourself in that situation? What can you do?

Let’s start with what you can do to keep RMDs from draining your pretax accounts.

Your best defense here is an annuity, which is like a personal pension in that it guarantees to pay you monthly income checks for as long as you live. That guarantee is the defense against the threat to your income posed by RMDs. But don’t run out this moment and put all of your pretax money into an annuity. As I explained previously, there are a number of questions that need to be addressed in order to ascertain if an annuity makes sense for you in your situation.

Another trick that could come in handy is the fact that, if you have multiple pretax IRAs, you can add up your RMDs from each of those IRAs and then withdraw that total amount from any one (or more) of those IRAs. For example, let’s say that you have three IRAs, and your RMD from each is $100. This means your total RMD from the three accounts combined is $300. But instead of withdrawing $100 from each account, you can opt to withdraw the full $300 from just one of them, leaving the other two to continue compounding uninterrupted. This trick won’t solve the problem permanently like an annuity would, but it might allow you to get more mileage out of your pretax money than you’d get by drawing RMDs from each account individually. Note that this ability to “aggregate” RMDs applies only to IRAs that are in your name. If you have pretax money in a 401(k) or other workplace retirement plan, your RMDs for that money have to be withdrawn from that account. Likewise, if you have an inherited IRA (which will still be in the deceased’s name even though the money inside it is now yours to control), you can’t satisfy RMDs for that account using money from an IRA that’s in your name (or vice versa). Also, if one of your pretax IRAs is in the form of an annuity with a living benefit, you’ll most likely want to keep the RMD for that annuity separate from your other IRAs. This is because the typical living benefit stipulates that if your RMD for the annuity in any year is greater than the sum of your monthly checks for that year, the insurance company will increase your monthly checks for that year without reducing the guaranteed size of your monthly checks in the future. For example, let’s say that you’ve “turned on the faucet” of lifetime income, and your monthly checks are guaranteed to be at least $500. Now, let’s say that at the start of a new year, the insurance company determines that your RMD for the annuity this year will be $6900. Twelve monthly payments of $500 would add up to $6000, leaving you $900 short. To compensate, the insurance company will increase your monthly checks for the year to $575, while still honoring their guarantee to pay you at least $500/month for the rest of your life. However, this service extends only as far as the RMDs for that annuity. Continuing with the preceding scenario, if you withdrew more than $6900 that year to satisfy RMDs from other IRAs, it would be considered an “excess withdrawal” and would lower the size of your income checks going forward. At the same time, if you withdrew your RMD for the annuity from another (non-annuity) IRA, that would be a waste; you’d be drawing from an exhaustible source of income when you had the opportunity to draw from an inexhaustible source.

Finally, if you have a Roth account inside a 401(k) or other workplace retirement plan, you still have to follow the same rules for RMDs as a pretax account in the same plan. Although you won’t have to pay taxes on those RMDs, if you don’t yet need the income, it would be nice to have the option to keep that money where it is and let it compound further, so that you’ll have even more tax-free money to draw upon down the road. Fortunately, there’s an easy workaround: roll the money in that Roth account over to a Roth IRA. Of course, a Roth IRA is more restrictive in terms of your ability to make contributions, but that may be of little or no consequence if you’re no longer working full-time.

Now let’s talk about what you can do to ease the tax burden of RMDs.

If you feel comfortable donating the money to charity, then you can have part or all of your RMD (up to $100K per year) sent directly to a qualifying charity. This is what’s called a qualified charitable distribution, and instead of increasing your tax bill for that year (as an RMD normally would), it actually lowers it! And that’s in addition to any “regular” tax-deductible donations you make that year. The key is that the money has to go directly to the charity (it can’t be sent to you first), and it has to come from an IRA that doesn’t allow new contributions after 70½ (in other words, not a SEP or SIMPLE IRA).

If, on the other hand, you don’t want to donate any of your pretax money, another option is to purchase a special class of annuity. Any annuity can guarantee that the pretax money it houses will never run out, but there are some that also let you defer withdrawals (including RMDs) until as late as age 85. I’m talking about annuities that are eligible to be designated a QLAC (qualifying longevity annuity contract). The QLAC designation means you can take pretax money and shield it from RMDs all the way up to your 85th birthday (or rather the first day of the month following your 85th birthday). This allows you to lower your tax burden for several years without having to give any of that money away. However, there are a couple of caveats. First, a QLAC doesn’t have an account value that you can cash out down the road (if you were to so choose). It’s just a contract that spells out how much your monthly checks will be depending on the age at which you start collecting them (which is up to you). And when you do initiate the stream of monthly checks, the contract will be annuitized. This means that, if you pass away before all of the money you paid in has come back to you, the insurance company gets to keep the remainder, unless you specified at the time of annuitization that you want any unused portion of your money to be “refunded” and sent to a beneficiary of your choosing. However, annuity contracts aren’t required to provide such an option, so if it’s important to you, make sure the QLAC you’re considering does give you that option. (On the plus side, when an annuity is annuitized, the monthly checks don’t have to conform to any RMD timetables.) Second, you can’t shelter all of your pretax money in a QLAC. The most you can shelter is 25% of all of your pretax money, and no more than $130,000. For example, if your total sum of pretax money is $400K, you can't put more than $100K (= 25% of $400K) into a QLAC, and if your total sum of pretax money is $800K, you can't put more than $130K into a QLAC (even though that's less than 25% of $800K).

If you’re still working or actively engaged in a business past the age of 70½, there are two other loopholes to explore. The first is that you can continue contributing to the retirement plan even as you’re taking RMDs. This will at least offset the yearly hit to your tax bill until you retire. The second loophole comes into play if you’re working as someone else’s employee. The tax code allows employees to defer RMDs from their workplace retirement plan until April 1 of the year after they retire (even if that’s well after they’ve turned 70½). (This exception doesn’t apply if (a) your workplace plan is a defined benefit plan or some type of IRA, or (b) the workplace is a business in which you own a stake of 5% or more.) However, even if you qualify for this loophole, the tax code doesn’t guarantee you’ll be able to take advantage of it. It depends on whether or not such a provision has been included in the plan specs. To see if your plan allows you to take advantage of this loophole, check the summary plan description (which you should be able to find on your employer’s online benefits portal or get a copy of from HR).