RMDs: The Basics

This is Mr. Stillman's Opus, Walter Storholdt with you today as host alongside the founder of Rosewood Wealth Management, Mr. Jon Stillman.

Hey, Jon. What's happening? We're talking about RMDs today. Your favorite topic?

Everyone's favorite topic. Everybody gets really excited about the fact that they have to take their RMDs. Yes, exactly. So RMDs are required minimum distributions.

A lot of the times, even though I know what they mean, that verbiage just kind of goes into my head and dissolves. What are we talking about when we talk about required minimum distributions? Yep, and some people call it MRDs, minimum required distributions. It's all the same. RMDs or MRDs, if you hear that, it's all the same. If you hear MREs, that's different. That's military. That's meals ready to eat. I'd rather that. Yeah.

Everybody would rather have MREs than MRDs or RMDs. In any event, basically, you enter into a contract with Uncle Sam whenever you contribute money to a tax-deferred account. A tax-deferred account would be a 401k, an IRA, if you're a federal employee, your TSP, your Thrift Savings Plan, if you work for a school or a nonprofit, a 403b. What about a Roth IRA?

That's part of this category. That would be tax-free. We're talking here about tax-deferred accounts. Just qualified, the word qualified, equal tax-deferred typically? Well, qualified actually would encompass both tax-free Roth and traditional IRA.

Qualified would be like an umbrella over above that, basically talking about any sort of retirement plan. What we're talking about here is money where you've put it in, you've contributed that money and you didn't pay taxes on it that year. If you maxed out, if you're 50 years old and you max out your 401k at $24,000, you have a $100,000 salary, you put $24,000 in your 401k, well, the IRS says that you only had a $76,000 income that year because you put $24,000 into the 401k. When you do that, you enter into a contract with Uncle Sam that says, I understand that I'm not paying the taxes now on this money, but I'm going to let it grow and I'm going to use it for my retirement and when I retire, I'm going to take the money out and I'm going to pay taxes on it, everything I've contributed, as well as all the growth on those contributions, I'm going to pay the taxes at that point.

Well, let's suppose you get to the ripe old age of 70 and a half. Why does the IRS make it 70 and a half? I've never heard anybody explain that, but if you get to age 70 and a half and you haven't taken money out of your retirement account yet, why might you have done that? Well, maybe you retired and you had a nice pension, you had a nice social security benefit, maybe you own a couple of rental properties and those are giving you income. Maybe you didn't need any of the money in your 401k or your IRA to fund your lifestyle. Well, the government starts to get antsy once you hit age 70 and a half and they say, yeah, we really want some revenue from these tax dollars. You're no longer allowed to keep deferring that forever. We are requiring you to start taking money out of those accounts so that we can tax it. Most folks don't realize that that's the contract that they entered into with Uncle Sam, but that is the case. Any of those tax deferred accounts, once you hit 70 and a half, you're going to have to start taking some out every single year, whether you need it or not, because the government wants their tax revenue.

And that's why they want it. So are there any ways to avoid doing this? Let's say we don't want to withdraw that money. If you're waking up at 70 and a half and saying, how do I get around this?

No, there's really not a way to avoid it. I mean, what you can do if you don't want to deal with the withdrawal portion, you can just send the RMD straight to a nonprofit. So let's say your RMD is $10,000 you have to take out. Well, essentially the government is saying, all right, take out $10,000, give us 20% of it and you can keep 8,000. Well, if you just send the whole $10,000 to a nonprofit, you don't pay the taxes.

They don't pay the taxes. You don't of course get any of the money, but that kind of bypasses the whole instead of, you know, taking 10,000 out, donating it to the nonprofit and then having to list that deduction on your taxes so that you get a refund and you get the $2,000 at the end of the day, you can just send it straight to the nonprofit. So if you want to say that's getting around it, fine. It's not really getting around it. You still have to take the money out of the account. So the only way to really quote unquote get around it is to not put the money in in the first place, is to contribute to your retirement savings differently on the front end.

But once it's done, it's done. There's really no escaping. So there's no offshore accounts we can utilize or anything like that, right?

No secret islands that we can ship our money to. The Dutch sandwich approach. Yeah, there you go. I think they're getting rid of some of those tax loopholes. Unfortunately, the Dutch sandwich will no longer be a thing. Unfortunate.

They're going to get it one way, shape or form. By the way, the Dutch sandwich is not something they serve at Merritt's Grill in Chapel Hill. It's actually a tax loophole that comes with a very fascinating chart, if you ever want to look that up. Called the Dutch sandwich. Yeah. How about that? Can you, John, give us an example of a situation you've seen where somebody made a mess for themselves on the tax front because they inadequately planned for these RMDs.

They were in the crowd that kind of woke up at 70 and a half and realized, oh, I got to do something. Well, let's think about the example I just gave where you've got a nice Social Security benefit, nice pension, couple of rental incomes. That's all the income you need. Maybe that's paying you 10,000 a month between those income streams.

That's all you need for your income. And let's say you've amassed a million dollars in tax-deferred accounts by the time you hit 70 and a half. Well, you're going to have to take out in that first year's distribution about $36,000 to $37,000 of that million, you're going to be required to withdraw. So if you weren't planning for that in advance, that money could bump you up into another tax bracket. So you can end up in the highest tax bracket on that money that you're withdrawing and you're giving away more than a third of it to the government. So you want to, if possible, set your retirement income plan up in a way that the money that you have to take out for your RMDs is money that you need anyway. You want that to be money that you have to take out to fund your lifestyle, not money that you're being forced to take out whether you want it or not.

You want to be in a position where you want it. So when you get to 70 and a half, those RMDs, you're kind of thinking, and correct me if I'm wrong, in the order of operations, you want those to be the first things to come and start paying the budget down because you need that money to cover the budget. Other resources can then be your sort of fun money or, hey, now we've fulfilled the need. We don't need to pull those resources out.

Yep. If you need $10,000 a month for your income, you want your plan to include, you want your RMDs to be part of that 10,000 if at all possible. And you know what, if there's no avoiding it, if you end up with more income, you know, so be it. More income is still better than less income, but to the extent you can avoid it, yeah, you don't want to be bumping up into another tax bracket. It sounds like your baseline funds that you're pulling out are your minimum distribution and Social Security. By the time you're 70 and a half, because you're certainly drawing on Social Security at that point, and that's forming sort of your base level. Right.

Makes sense. All right, so that's a pretty good example, John. How do you plan, though, in such a way as to prevent RMDs from causing real tax problems down the line?

What can we do to be more proactive about those? Well, generally, you want to start the conversation as soon as your late 50s or early 60s and start putting that retirement income plan together that shows how is it that we're going to create our income in such a way that incorporates our tax deferred accounts and doesn't just assume that we can put that money off forever. For example, a few months ago, I was working with Tom and Diane. They were 68, getting ready to retire. They were selling their house, downsizing to a much smaller house, and they were going to end up with almost $250,000 in cash after downsizing to a smaller house, because they were selling like a $650,000 house. They were going to pay cash for $350,000 to $400,000 house.

Gotcha. And they've got all this excess cash that they'll have in the bank. Well, what they're thinking was, all right, we're 68. We're going to put that money in the bank, and we'll just draw down that money from the bank for probably seven to eight years is all we'll need, because they had pensions.

They had Social Security. They didn't need to take but $2,000 or $3,000 a month from that pot in the bank. So they're thinking, that will last us several years. So they said, look, we don't need any of this money in the IRA for seven or eight years. So we're going to invest that, not super aggressively, but we don't have to be too conservative with it because we don't need that money for seven or eight years. Well, again, they were 68.

Yes, they didn't need the money for seven or eight years, but they were going to be required to start taking some of the money in a couple of years, whether they wanted to or not. So we needed to invest enough money within the account, within the IRAs, so that it was conservative, and we knew that it was going to be there when they had to start taking the money out. Because everybody understands buy low and sell high, right? Well, you don't ever want to sell low. You don't ever want to be forced into a situation where you have to sell low. And if you have to take money out of your IRA to create income, you're selling. You're selling to do that. And if the market happens to be down, your hand is forced.

You have to sell low. And so we want to create a situation where you have assets that you can sell to create your income without ever being forced to sell low, if that makes sense. These numbers may not make sense, but I think the concept does of, let's say you've got $200,000.

You know you're going to have to take RMD, so you're going to take $100,000 and put it in very stable, safe assets, because you know you're going to need that for a period of five, six years of RMDs. But the other $100,000 you can take a little bit more risk with. Let's look at it in really simple math terms. Let's say you have a million dollars, and let's split it in half. Let's say $500,000 goes into an aggressive pot, and $500,000 goes into a conservative pot. Okay? Well, let's say the market's up.

You get to your age 70 and a half. You have to take money out. We're going to take it from the aggressive side. We're going to take it out of the side that's up. We're going to sell high from that side to create our income. What if the market's down? Well, we don't want to sell low in that account, so we're going to take it out of the conservative side, which isn't down nearly as much. That's where we're going to generate the income from in that particular year. Most people have not planned like that ahead of time to be sure that they're making the most of their investment. On one hand, it's a tax problem, but on the other hand, it's an investment problem, because if you're being forced to sell anything, that can create problems if you didn't plan well enough.

It's a timing problem on top of all that as well. That, to me, is the true difference of financial planning, of what you do. Anybody can look and say, all right, at 70 and a half, I've got to withdraw money.

That's the next-gen stats if you're following sports or something like that. That's the next level of planning that you can get into. Yep, and it's amazing how many people just haven't thought through the implications of their RMDs, because they hear, all right, well, I have to take money out when I'm 70 and a half. I'll deal with it then.

Well, no, you really need to start the planning process several years in advance of that. All right, I think that's a pretty good way to end the conversation, hearing about John's sort of spidey sense, how he's able to kind of figure out this tax plan, this investing issue that pops up with RMDs. How are you going to ever figure that out on your own, or at least the majority of us, I'm sure.

That makes your head spin a little bit. So if you need John's help, need some guidance when it comes to planning for your RMDs, whether you're in that category of, oops, I've gotten pretty close to 70 and a half. Now I have to figure out what to do, or you're in that ballpark of, you know, 50s, early 60s, somewhere in that range, and you want to start planning a little bit better for your future RMDs, reach out, set up that time to meet, have that conversation. 391-3446 is the number, 919 area code. So that's 919-391-3446, or always online at RosewoodWealthManagement.com. RosewoodWealthManagement.com. For John, I'm Walter. We'll talk to you next time on Mr. Stillman's Opus.