Income Investing And Planning For The Dreaded Required Minimum Distributions

by: Bruce Miller

Summary

If planned well, the Required Minimum Distribution should be a non-event for the income portfolio.

For some, the Required Minimum Distribution will be a tax event only.

Careful planning will help prevent the Required Minimum Distribution from becoming a cash flow event.

If I've read it once, I've read it a hundred times: the perplexed retiree coming up on Required Minimum Distributions (RMDs) will muse that he now must use this RMD for this or that cash need. In this article, I'll attempt to make the case here that RMDs are not and should not be treated as a cash flow event for the retired household requiring ongoing income, whether from the Traditional IRA (TIRA), Employer Sponsored Retirement Plan (ESRP), nor from taxable investment accounts. The IRS does not require the RMD to be withdrawn as cash and consumed… it only requires that the RMD amount, whether in cash or the equivalent dollar value of shares of one or more securities, be removed from the IRA/ESRP and the taxable portion of this withdrawal (100% for most retirees) be included as ordinary income for that year.

For retired households, employing a pure income approach to investment management, if the dividends withdrawn exceed the RMD amount, the RMD will be a non-issue. For retired households, requiring less in withdrawals from the TIRA/ESRP than the RMD amount will thus create a tax event, which is to say the household tax expense will increase with the RMD year and if so, this may create a cash-flow event that may require the transfer of stock from the IRA and may require selling of securities to generate cash for the added tax. The best way to avoid the involuntary sale of investments to create required cash to pay the increased tax bill is through careful planning. Below, I give an example of this for a retired household using the IRA/ESRP for all household retirement income, for part of the retired household's required income and then for providing none of the household's required income. But first, let's do a quick review of the rules governing the RMD.

RMD Review

The year one attains the age 70-½ and becomes the first RMD year. As of the end of the day on December 31 of the year preceding the RMD year, the value of each TIRA (if more than one are held) along with the value of each SIMPLE IRA, SEP IRA and SARSEP IRA, if any, are determined (I will refer to these collectively as TIRAs as the IRS requires they all be combined in calculating the value of one's TIRA).

Each of these end-of-year values, if more than one, is then divided by the life expectancy of the IRA owner, as shown on the Uniform Table (Appendix B Table III of Pub 590-B) or, if the spouse is greater than 10 years younger than the TIRA owner, use of Table II (Appendix B of Pub 590-B). The age used for the table is the age of the IRA owner at the end of the RMD calendar year. So if the end of the previous year value of a TIRA is $200,000 and this TIRA owner will be 70 at the end of this first TIRA calendar year (their birth month was during the first 6 months of that year), then the RMD will be $200,000/27.4 (from the Uniform Table) = $7,299.

This calculated amount may be taken from that account or any of the other accounts, if there is more than one, providing the total distributions from all of them at least equal the total of all account RMDs. The first RMD must be taken by April 1 of the following year (referred to as the Required Beginning Date or RBD), but this only applies to the first RMD. All subsequent year RMDs must be removed from the IRA by 12/31 of the RMD year. What is a bit unique about the TIRA RMD is that there are no exceptions to this requirement… with perhaps the one time in 2009 when Congress saw fit to suspend the RMD for that year only. Other than this, the TIRA RMD rule is one of the few rules that is absolute.

There are no RMDs for individual Roth IRAs (RIRA) while the owner is alive.

ESRPs must also determine their RMDs using the same method. However, each ESRP must make distributions separately, with one exception: if the retiree has more than one Sec. 403(b) plan, the calculated RMD from each may be combined and taken from one or a combination of the 403(b) plans. However, if the retiree is continuing to work for the employer and is not greater than a 5% owner of the company, the IRS allows the retiree/worker to defer the RMD for that year until the worker formally retires (discontinues working for the employer), which will then become the first RMD year with April 1 of the next year becoming the RBD.

The first case, let's apply these rules to a retired couple wishing to use the income method of managing their TIRA/ESRP retirement accounts for reliable income that grows each year with inflation to maintain purchasing power.

The Case of Lee and Ariel Owenski

Lee and Ariel have been retired since age 64 in 2010. They have no pensions, with all retirement savings through their employers 401(k) and their deductible contributions to their TIRAs over their working years. They have rolled over their 401(k) balances to their TIRAs and wish to use a pure income approach to providing retirement income from these savings. Over the past 7 years, they have invested in dividend paying stocks, MLPs and REIT stocks, today holding 52 such income securities. Their focus is on long-term dividend paying companies with a mix of fixed income preferred stock and stocks with a history of consistent dividend growth.

They have chosen these securities for their long-term reliable distributions. They are confident it will continue over their retirement years without having to regularly sell their holdings to be able to generate household income. All of their retirement savings they wish to invest for reliable income are in their TIRAs with a smaller amount held in taxable accounts they wish to hold for emergency and unplanned use in future years. They have paid off their home mortgage thus have no mortgage interest deduction and they live in Washington State that has no state tax. As a result, their itemized deductions are less than the standard deduction, so they take the standard deduction. This is their relevant financial information:

This shows that this couple are well within the 15% Fed tax bracket, with all TIRA dividend withdrawals and 85% of Social Security benefits being taxed as ordinary income.

As can be seen, the RMD amount is less than their actual withdrawal of the dividends from their investments in their TIRAs. Thus, the RMD is a non-event, and will remain so until the RMD percent exceeds their income portfolio current yield... which is another way of saying when the RMD amount exceeds the total dividends paid out (and distributed) by the income portfolio in the TIRA/ESRP.

As can be seen from this table, the percent of the account balance that must be withdrawn as the RMD will increase each year based on a decreasing life expectancy in the denominator, but also based on the size of the TIRA/ESRP. What is a bit of a challenge to the income investing household is that unlike those employing total return, the size of the account(s) is not decreasing with annual withdrawals. However, if the total of distributed dividends equals or exceeds the RMD and the portfolio dividend growth rate stays above the growth rate of the RMD, then the RMD will continue to be a non-issue. This will be the case for most in the early years, as most income portfolios will have yields exceeding 3.6% and portfolio income growth rates greater than 3.4%. Not all... but many will.

The second case comes up if the RMD exceeds the dividends produced in the TIRA/ESRP. Under such circumstances, the retiree(s) should do two things:

  1. At the beginning of the RMD year, transfer in-kind the number of shares of an income security whose value, when added to the dividends projected to be distributed that year, will at least equal the RMD. This process preserves the dividend paying ability of the income portfolio while meeting the RMD requirement.
  2. Come up with the added cash needed to pay the increased tax bill. In the early years, this tax bill should be a modest increase over the 'normal' income tax paid by the household and so, this cost may simply be absorbed by the household's existing cash flows. For example, if the RMD is $40,000 and the dividend distribution is $39,000 from the TIRA, an added $1,000 will need to be transferred out. This is usually best done by transferring in-kind $1,000 worth of a qualified dividend paying stock at the beginning of the year, so as to be able to collect all qualified dividends in the taxable account. This in-kind transfer will meet the RMD requirement, but will also create an added 0.15 X 1,000 = $150 in Fed income tax. To help offset this added cost, the years' dividend paid by this transferred stock will be qualified and for most retired households in the 15% marginal tax bracket, will be subject to 0% tax instead of the 15% rate the dividends had been subject to when paid in and then distributed from the TIRA that year. But this will likely be a gradual process and so must be monitored in later years for a possible widespread between the RMD and the total of dividends paid out of the TIRA/ESRP that may be large enough to require the sale of income producing assets within the TIRA/ESRP to generate sufficient cash to pay the added tax.

The final situation is where the household is using taxable accounts for holding income securities and the TIRA/ESRP is not used to produce required income. Here is where careful advanced planning will make this tax event much more palatable. Going back to the Owenskis, let's say they have amassed sufficient savings in taxable accounts through, say, an inheritance or sale of real estate, such that using these savings to invest in dividend paying stocks will meet their retirement income requirement, but they continue to save through their 401(k)s as shown previously, going into retirement with the same amount.

By investing in dividend paying stocks within the TIRA/ESRP at or even before retirement (age 64 in this case), reinvesting the dividends and then getting to the first RMD year will create the same RMD as shown earlier. But here, they can transfer in-kind sufficient shares of a high dividend paying stock to meet the RMD and then use the new dividend as an offset to the increased tax bill. For example:

Here, the Owenskis had purchased several hundred shares of SO in their IRA(s) in years past, reinvesting the dividends over the years. At the first RMD year, they transferred at the beginning of the year 725 of these shares in-kind to their taxable account where it pays a 4.5% yield. This will be used to offset the 15% Federal tax on the RMD, thus effectively reducing it to an 11.5% tax. The $36,134 of ordinary income created by the transfer will leave about $19,000 in the 15% bracket for the qualified dividends from their income portfolio, leaving about $20,000 of remaining qualified dividends that will be taxed at the 15% rate. The additional cash to pay the additional tax will, for most, have to come from cash withdrawn from the TIRA/ESRP. But this will have no impact on the required household income cash flow from the taxable account.

Conclusion:

For the income investing retired household, RMD planning should begin early, particularly if the TIRA/ESRP is required for producing required long-term reliable household income using the pure income approach. As I was once reminded, the value shown on my annual TIRA statement is not mine... only a portion of it is... the other portion belongs to the IRS and they are being kind enough to let me keep it for them until mandatory transfers begin at age 70-½ and beyond. Through careful planning, I can limit the amount that is transferred to the IRS without disrupting the income generated from my income portfolio.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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