Strolling through the annual San Francisco Automobile show over Thanksgiving, I heard a remark about someone who couldn’t think of what to do with the Required Minimum Distribution (“RMD”) from their IRA. “I think I’ll buy a car,” was what they had reportedly decided.
For some people, the dreaded RMD is just a nuisance. At age 70 and a half when we have to start taking money out of our Individual Retirement Accounts, many would much prefer leave it for a rainy day --- like the day when nursing home care costs us $5,000 to $10,000 per month. Those future clouds on the horizon can be daunting.
The government’s rationale for forcing retirees to liquidate their IRA’s is fundamentally commendable. The intention for granting tax deductions for contributions, plus tax-deferred compound annual earnings, was to give Americans the most advantageous opportunity to save for their own retirements. It was never intended to become a tool for passing assets on to future generations so we would wind up with a nation of government subsidized Downton Abby’s.
The RMD starts out at less than 4 percent of your nest egg, and even by the time you’re 80, the annual distribution percentage is still less than 6 percent of your total IRA assets. Hopefully, with at least some money still in blue chip stocks, the account will still be growing to some extent in an effort to offset those distributions.
Still, many retirees who have settled in to a lifestyle supported by social security and other assets providing income can be surprised when suddenly the RMD creates money that they had forgotten they had to take --- and that they had been doing fine without.
Taxed at the highest marginal tax bracket, this excess money for most people is taxed at 35 percent, so that makes the payments even more annoying for those who would rather have left it alone. However, nobody says you have to spend what you receive as the after–tax “take-home pay” from your RMD. You can always just invest it the same way you invest other after-tax, non-retirement plan assets.
However, after-tax money is more difficult to manage than your old tax-sheltered IRA or 401k/403b money because now anything you earn will be taxed as well from year to year. One antidote is to consider index funds invested in stocks that do very little trading. Turn-over in these funds it typically less than 6 percent per year which means that very little will be owed in capital gains taxes until you eventually start selling some of the shares.
Taking the trouble to learn how your typical mutual funds trigger annual taxable income to you is important when you are investing after–tax money. Index funds or Exchange-traded funds (ETF’s) that invest in various indices can offer most of the same advantage of tax-free buildup until you actually need to spend the money. Another tool, tax-managed mutual funds, are operated in a way that balances gains with losses from year to year to minimize the tax impact.
Unfortunately, their performance history suffers when they have, as their first priority, the reduction of taxes over what should be just the best investment results. Finally, high yield tax-free municipal bond funds are worth considering to generate what in California would be about 4 percent currently.
Don’t forget that you can give the money to charity directly and avoid the income tax on the distributions themselves. If you want to think about it, there are “donor – advised” funds that offer a tax deduction for the contribution but you don’t have to specify immediately who you want the money to go to. It just sits there compounding tax free over the years until you decide who the charities are that you want to support --- and by how much and when.
For many of us, contemplating what could be the nuisance factor of a future RMD is a delightful problem to imagine having. In the meantime, we still have to work, save and invest effectively to get there. A good New Year’s resolution for most of us would be to increase our annual retirement contribution levels and to read a few more books on how to invest.