“Planning for RMDs shouldn’t begin at age 70; it should be well in advance of that,” Ms. Bruno said. “Once you’re at 70½, you have no choice—you just have to take the money.”
The IRS sets RMDs, which are the minimum annual amounts that must be taken out of a tax-deferred retirement account such as a 401(k) plan or traditional IRA. You must start withdrawing from these accounts once you turn 70½, and you must pay income tax on the distributions. The IRS imposes penalties for withdrawing less than the minimum. Withdrawal rates are based on a life expectancy table administered by the IRS.
Defining the terms
“It’s actually a ‘percent-of-portfolio distribution,’ but the IRS is mandating what that distribution percentage is,” Ms. Bruno said. (The percentage roughly tracks 4% for several years into retirement.)
As such, the distributions also depend on market performance, so they’ll fluctuate. In up markets, your RMD might be higher, which “can be good and bad.” If the RMD is needed as an income source, a larger RMD could meet that need, “but it also would result in greater income taxes because the distribution is greater,” she said.
The traditional 4% spending rule, on the other hand, is a dollar inflation-adjusted strategy. It suggests that retirees can safely take 4% from a balanced portfolio in the first year, then adjust the amount for inflation each year after that to offer a strong likelihood of not running out of money over a 30-year period.
“It’s meant to provide a predictable income stream, but it completely ignores market performance,” Ms. Bruno said. “And we know, realistically, that retirees don’t spend like that. They do some type of hybrid method.”
For example, in up markets, retirees can cap what they spend and reinvest the rest, she said. That method provides a buffer in down markets so retirees don’t have to decrease their spending as much. “It’s a percent-of-portfolio strategy with some guardrails around it, and it’s the strategy Vanguard recommends,” Ms. Bruno said.
She noted that even though the IRS mandates the RMDs, retirees are not required to spend them. More affluent retirees sometimes ask how to invest distributions that they don’t immediately need. Vanguard research has found that up to 20% of retirees reinvest the money in a nonretirement account, Ms. Bruno said.
It’s not required minimum spending
To determine what strategies could be used, those close to retirement might work with an advisor or an accountant to learn “what the RMD picture and tax picture would look like for you.”
Many retirees—accustomed to having an employer withhold taxes from their paycheck—have to think about taxes in a new way. In retirement, taxes “become a line item in the budget,” Ms. Bruno said.
Sizable tax-deferred portfolios and Social Security could potentially push some retirees into a higher marginal tax bracket once RMDs start.
On the other hand, income could be relatively lower in the early years of retirement, putting some retirees in a lower bracket. It might make sense for these retirees “to accelerate some IRA distributions because they would be taxed, presumably, at the lower marginal rate.” Another option is to do a series of partial conversions from traditional to Roth IRAs as a way to build tax diversification, she said.
Taking your RMD can kill two birds with one stone: In addition to satisfying the IRS requirement, you could use the withdrawal to rebalance your portfolio. For instance, if robust stock market gains have left your portfolio with a higher proportion of equities than is appropriate for your circumstances, you might take your RMD from the stock portion of your tax-deferred portfolio. That way, you can rebalance and not have to worry about adjusting your taxable portfolio and incurring additional taxes.
RMDs, if you’ve begun taking them, “should be the first source of where you spend from your portfolio,” Ms. Bruno said, because the distributions are required. The money can be placed in a money market or similar account.
The sequence of your withdrawals
If an RMD is more than you need for expenses, you can reinvest the money in a tax-efficient investment within your taxable portfolio.
If the RMD, on top of Social Security and other guaranteed income sources, is not enough to cover your expenses, you could turn to your nonretirement accounts, starting with investments that generate dividends or capital gains, which are subject to income tax. Instead of reinvesting those dividends, you could put them in the money market account as well.
When it comes to spending, flexibility is key, Ms. Bruno said: “If you use a percent-of-portfolio approach, then technically you can never run out of money, because it’s a percentage of the prior year balance. But if the portfolio is declining because of market conditions, the amount you can spend is less.”
However, if you use an inflation-adjusted strategy (the 4% spending rule), you could run out. Retiring in a sustained bear market puts you at risk of depleting your portfolio prematurely, because the method doesn’t readjust based on market performance.
Ms. Bruno noted that deciding on a spending strategy in retirement involves a series of tradeoffs, such as how much income variability you can accept and how much you should take market performance into account. This is why Vanguard recommends a percentage-of-portfolio approach with “ceiling and floor” guardrails.
“The key is to go back and revisit this, because the markets will affect what your portfolio balances look like,” she said.
Vanguard offers clients a free Required Minimum Distribution Service, which takes just a few minutes to set up. Before you begin, you’ll need to decide whether you’d like us to reinvest your RMD assets at Vanguard or deposit them at your bank.
How we can help
If you’re age 69½ or older, sign up now
We also can deposit the distribution in a Vanguard nonretirement account or a bank account and withhold federal taxes from the distribution.
All investments are subject to risk including the possible loss of the money you invest.
Consider consulting a tax advisor concerning your individual situation.
Consider the impact on your long-term investment strategy when making any transactions for tax purposes.