Transcript

Hi, Everyone. Welcome to the Wiser Financial Advisor with Josh Nelson, where we get real, we get honest, and we get clear about the financial world and your money.       

 This is Josh Nelson, Certified Financial Planner and founder and CEO of Keystone Financial Services. We love feedback and we’d love it if you would pass it on to me directly: josh@keystonefinancial.com . Also please stay plugged in with us, get updates on episodes and help us promote the podcast. You can subscribe to us at Apple Podcasts, Spotify or your favorite podcast service.

Let the financial fun begin!

Keystone Financial is here to help you make decisions about your money. We use wisdom collected from the past so as to learn from experience and from other people that have made mistakes.

As a financial advisor myself for 22 plus years at this point, I’ve seen a lot of things that have worked really well for people and a lot of things that have not worked so well. So I feel like I have things to share, and I’m glad you are here with me today. As always, please feel free to share this with anybody that you think would benefit from it. These topics are meant to trigger conversations; they are not the be-all end-all for financial planning advice.

Today we’re going to talk about Required Minimum Distributions, otherwise known as RMD. A lot of you have probably heard of this. Required Minimum Distribution is simply the amount you’re required to take out of your retirement accounts, even if you don’t want to.

We’re going to unpack this. You might say, “Well, why would I have to? Why would somebody be making me do that?”

What we’re talking about here is your pretax retirement accounts. Things like an IRA (Individual Retirement Account), or 401K or 403B. These have been pretax contributions either from you or your employer, and so the taxes haven’t been paid on that money yet. Lawmakers want you to start paying those taxes. There have been a couple of changes made to this over the years, and some haven’t helped much at all. But most recently, the age has been increased. It used to be that age 70 ½ was the first age you would have to take an RMD. The age now is 72. So, you do have a little bit more time until you’re required to start.

We do watch this, of course, because there have been various pieces of legislation considered that would raise the age even further. The reason is because people are living longer, and if people are living longer, one concern is making sure their money is not going to outlast them. The number one fear of retirees is running out of money, so a lot of people welcome that increase to age 72, and hope that in the future, lawmakers raise it further. The bottom line is, nobody likes something that’s required. We want to be able to have flexibility and control our own destiny, but the Required Minimum Distribution is there because they want people to start paying taxes on the money.

Your first Required Minimum Distribution is age 72, but there are some curveballs to this. You have to look at a couple factors to know how much is required to take out. Number one is how old you are. The IRS has tables that show how much you have to take out each year based on how old you are. It’s a percentage. There’s also a factor based on your retirement funds balance from the prior year. The IRS wants you to add those funds all together. Here we’re talking about just the traditional, pretax variety of funds, not Roth funds which have already had their taxes paid. So those are the two things we need to know to be able to tell you how much your required distribution is going to be. Of course, if you’re a client of ours, we figure this out for you, and we make sure that you take it out so you’re not penalized.

Bottom line: Two things enter into the calculation: your age and also the balance of your retirement funds that are pretax. Balanced from the prior year means the collective balance. The IRS doesn’t care where you take it from; they just want you to pay the taxes.

Okay, so the IRS will have a table that uses your age and the balance of your retirement funds from the prior year. That will tell you how much you need to take out. I just looked at the table. For somebody who’s age 72, if this is the first year you’re required to take RMD, the percentage is roughly 3.8% of the total balance. That works out just fine, at least in the beginning, even if all your money was in retirement funds, because you know our 4% rule: we don’t like you taking more than 4% of your investment out in a given year, because if you go higher than that, it makes us start to worry about you running out of money sometime in your retirement.

There are a couple nuances to this. One: years ago when lawmakers put this into place, they said we’re going to require these distributions, but we are going to give people a little grace because we know the first time it’s required, people may forget about it. Maybe they go to their CPA and their CPA says, “You didn’t take your required distribution.” That gives people a little extra time, so their required beginning date for someone age 72 is April 1st of the year following the year when they turn 72. Please recognize that that the only time that applies is in the first year of RMD. You get a few extra months to take that required distribution from the prior year. In all the years following, you have to take it by December 31st of that particular year, and you’ve got to re-factor it every year. (Again, if you’re a client, we figure this out for you. We actually run reports at the end of the year just to make sure there are no stragglers, people who didn’t take their distributions out.)

There’s a big consequence if you don’t take RMD. The IRS says we’re going to make it really painful if you don’t take it out; we’re going to penalize you 50 %! That’s 50 % of the required amount going to the IRS in the form of a penalty—on top of income taxes. Believe it or not, you might actually lose the majority of your required distribution if you don’t take it out. So unless you really like giving money to the IRS, it’s a good idea for you to take your RMD by the time it’s supposed to come out.

Another nuance to throw out is that RMDs apply to those age 72 or older if they have qualified funds—and that does apply to everybody. It doesn’t matter if you inherited those funds from a spouse, you also need to start taking it out when you reach age 72. You do have the flexibility if your spouse passes away and you inherit their IRAs, you can fold them into your own IRAs. Depending on the ages of the spouses, that might help or hurt you. Bottom line, it does have to come out at age 72 or older.

There’s another nuance to think about regarding inherited IRAs. You can inherit money from somebody else who had a retirement account if you are named as the beneficiary on that account. A spouse can just fold the money into their own retirement account, but if you’re not the spouse—if you’re a kid, cousin, friend or whoever—you will need to move that money into an inherited IRA. The old rule said that you would then be able to use what was called the stretch IRA provision. Stretch IRA distributions allowed you to spread out the distributions based on your life expectancy, so it was a pretty big deal. Let’s say a 20-something ended up inheriting money from their grandfather and now they’ve got a big chunk of money in an inherited traditional IRA. That money could be spread out over their entire life expectancy.

Then Congress screwed up a lot of my clients’ estate plans. Many of our clients have large amounts of their net worth tied up in qualified retirement plans that these RMD rules would apply to. But now the rule is: when you inherit an IRA, you have to liquidate it by 10 years from the person’s death. That can dramatically shrink down the number of years that money would be allowed to be tax-deferred. Depending on the size of the qualified retirement funds, it could be a big chunk of money that would end up coming out. Some people will elect to spread that out over 10 years, which is maybe not that big of a deal, but the loss of tax deferred growth, if you do the math, ends up being a big amount of money over time. That change was part of the 2017 tax bill. Not thrilled about that for a lot of our clients, but that’s just the way it goes sometimes.

One thing to just note, I think it’s important to recognize that Congress can change the rules whenever they want to change them if they get enough lawmakers that decide to put something into play. So, it doesn’t matter what your plans were in the past once the laws have changed.

As we’re talking about all this stuff, I like to recognize that flexibility and being adaptable are really important because there could be some future Congress down the road that ends up messing up your plans as far as passing on your wealth or distributing your funds over retirement. They might mess with that and they do mess with that, so you need to be nimble when it comes to your planning.

Ultimately, what can you do? A lot of people get frustrated. They hear the explanation behind all this and they say, “I don’t like it. I don’t like how this works.” Well, don’t fight reality. There’s no way around it, but there are some things you can do that will help out. One of those is to set up something called a qualified gift charity out of your required distribution. There are some nuances around this. You want to be careful how you do it, but we have a number of clients that do this because they’re able to make a direct transfer to charity from their required distribution. That direct transfer to charity is not taxable, either to the owner of the IRA or other qualified retirement plan or the charity. (Of course, if it’s 501C3, they’re a charity and don’t pay taxes on those sorts of things.)

So, distributions from retirement funds can actually go out this way. The rule right now is up to $100,000 of an RMD can be donated that way. Of course, to have a $100,000 RMD you’d have to have a monster retirement account. We don’t run across those very often, but sometimes it happens.

Besides that, there are a few other suggestions on how to plan ahead if you are not age 72 and above. Maybe you’ve got a number of years until you get to that point, and maybe your parents or grandparents are there right now and you say, “I don’t like this. I don’t like how this works. I’d like to get around this somehow.”

Well, there are some ways. The charity thing is number one, but there are a few other things I like to point out to clients when we’re trying to plan ahead for a future that’s unpredictable. Let’s say you’ve got 20, 30 or even 40 years until you reach age 72. That’s a lot of time, a lot of presidents, a lot of Congresses, which means a lot of changes to the tax code, so it’s important to recognize that you won’t be able to predict what happens over those decades. Nobody can. Therefore, we do need to do some planning ahead to put ourselves into a position where we can be nimble and flexible and adapt to the circumstances over time as they change.

Number one is to be diversified. I’m not talking about investment diversification here, I’m talking about tax diversification. To be diversified from a tax standpoint, don’t have all your money in one tax basket. When you think about qualified retirement funds, what you’ve been doing is putting money away for years and years probably, and you’ve gotten tax benefits doing that. You’ve been able to deduct those expenses, either by having them taken out pretax, or if you made a Traditional IRA contribution, it was tax deferred.

Sometimes people do such a good job of putting money in retirement funds that they end up with a monster retirement account. It’s all pretax and they don’t have other tax categories that they can pull money from so they end up with huge RMDs and not a lot of tax flexibility. As I mentioned before, some of these people planned on those stretch IRA provisions staying around. They didn’t have tax diversification because they didn’t think they needed to. They thought that those stretch distributions would spread out the tax liability for their kids over time and wouldn’t be that big of a deal. Now it’s a really big deal for those folks.

So if we have a chance to plan ahead, we recommend you be diversified from a tax standpoint, meaning have funds in all three of the following categories:

Traditional or pretax funds, which could either be a 401K or an IRA, is money that has not yet been taxed.

Taxable investment accounts, which are investment accounts that aren’t tied to any special rules when it comes to retirement distributions. It’s good to have all three because there are lots of different rules we have to play by, and those rules change.

A Roth IRA or Roth 401K. Here the money has already been taxed and it’s going to come out tax-free and probably penalty-free later on as long as we play by the rules. That is a bucket of money that can grow tax-free and be distributed tax-free to you and your heirs down the road. I like Roth. Keystone Financial Services likes Roth during planning sessions with clients. We tell people, “If you can bite the bullet and stomach paying the taxes now by making Roth 401K contributions or Roth IRA contributions, what you’re giving up is the current deduction or current tax benefit you might be able to get from a Traditional IRA or Traditional 401K contribution. You’re saying you want to pay the taxes now on these dollars because the benefit of having tax-free distributions down the road, both to you and your heirs, would be a really good thing.” Retirement distributions are not required from Roth funds, at least right now. There are no Required Minimum Distributions; they do not require you to start taking money out at a certain age, so there’s more flexibility.

Roth funds look pretty attractive, especially if we’re talking to people who have a lot of time until they’re planning to take the money out. If you’re young, if you’re starting out in your 20s, 30s, even 40s, there’s a lot of advantage you’ll get. Look at the number of years you have for this money to grow.

Finally, a good strategy to follow is to have a financial plan around all of this. These things are not inside little bubbles of decisions. They will all impact each other because so many things are interrelated and there are so many moving parts. We always recommend you have a third party fiduciary, a Certified Financial Planner to help you with your plan, keep you accountable, and help you see what you don’t see. And the reality is that all of us have things we don’t see.

That’s always a benefit of game coaching—there’s somebody else out there to see what we don’t. They give advice, give their thoughts and experience. And the Certified Financial Planner is a fiduciary that’s compensated to help you and your family succeed over time.

To sum up, the three things we like to do when strategizing retirement funds are:

Be tax diversified. Make sure you’ve got different pieces of your pie when it comes to not only the diversification of your investments but also the diversification of your taxes. Have all three categories: traditional or pretax funds, Roth funds, and taxable investment accounts. There’s another rule regarding Traditional and Roth funds: they generally cannot be pulled out until age 59 ½, another magic age the IRS throws out there. That’s why we want to have taxable investment accounts—because we might need some funds earlier than that if we retire earlier, or if other things come up we need money to pay for.
Bite the bullet and pay the taxes upfront by contributing to a Roth account. You can do a Roth conversion if say you’ve already got a bucket of traditional money that you’re ready to pay the taxes on. Roth conversions currently have no income limits, so you can make as much money as you want and still do Roth conversions. (Of course, that can change over time.)
Have a financial plan and a Certified Financial Planner helping you.
Those are the things we like to talk about with clients when it comes to required distributions, also recognizing that these are the rules today and will change over time. We don’t say, “They could change.” We assume they will change a bunch over time, which is why we want to be nimble with our planning. Things will change based on what Congress does down the road and based on how our own lives change and our company benefits change. These are things we don’t necessarily have control over, but we have the ability to be nimble.

Hey, I would like to thank you. We just hit our 3000th download on the Wiser Financial Advisor, so thank you so much for being a part of what we’re doing here. We always like to get feedback, so feel free to email us with any topics and ideas. We’re also going to be incorporating more interviews coming up in 2022, so stay tuned.

Have an outstanding week and God bless.

This episode has been prepared for informational purposes only and is not intended to provide and should not be relied upon for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors. Investment advisory services offered through Keystone Financial Services, an SEC registered investment advisor.