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Benz: What to Do With Unneeded RMDs

Morningstar's Christine Benz shares a few tax-efficient options for retirees who don't need their required minimum distributions.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We may have just finished 2016's RMD season, but our director of personal finance, Christine Benz, thinks it's not too early for investors to think about their 2017 required minimum distributions, particularly if they are in that enviable position of having more than enough to live on without those RMDs.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: Let's just start by defining a few terms. RMDs, required minimum distributions: What are they and who does have to take them?

Benz: So, if you have assets that are in a traditional IRA, maybe a traditional company retirement plan, once you pass age 70 1/2, you need to begin taking these distributions. The amount that you take is calculated based on your life expectancy. You go on to the RMD tables and divide your balance by a factor to arrive at how much you need to take out each year. The basic idea is that if you've been taking advantage of these tax-sheltered investment vehicles over your accumulation years, at some point, the tax benefits have to come to an end, and the government starts to want to take a little bit of a piece of your assets. So, that's the basic idea behind RMDs.

Glaser: You're required to take distributions, but you're not required to spend it, of course.

Benz: Right.

Glaser: So, many retirees are taking this out of a tax-sheltered account, maybe they want to put it back into a tax-sheltered account. Is that something that's feasible?

Benz: Well, no. When it comes to a traditional IRA, you can't get the money back into the kitty once you've taken it out. And when you think about it, why would you even want to do that, because this account is subject to RMDs. So, you might be able to get it back in there, but you'll have to take it out at some point, at which point you'll owe taxes on it. So, you cannot get it back inside of a traditional IRA.

If you have some sort of earned income though--and so this wouldn't be income from Social Security, it wouldn't be income from your portfolio--if you have some sort of work income, enough to cover the amount of your contribution to a Roth IRA, then you can in fact make a Roth IRA contribution post-RMD age. And this is also true if you have a spouse who is still working. So, as long as the spouse has enough income to cover perhaps both of your Roth IRA contributions, you're OK. So, that's definitely something to consider.

I sometimes talk to retirees who say, you know, I was interested in working a little bit on a part-time basis, maybe doing some consulting in retirement, whatever it might be, and this was an additional impetus to consider doing so; I wanted to be able to take some of my RMDs and get them into something with some more favorable tax treatment than a taxable account.

Glaser: But if you have no earned income and your spouse has no earned income, do you have any options?

Benz: Not within retirement accounts. You'd need to turn to a nonretirement account, a traditional taxable account, taxable brokerage, or mutual fund account.

Glaser: So, if I'm looking at some of these traditional taxable accunts then, what are some steps I could take to reduce taxes or reduce the potential of tax liability down the road?

Benz: Well, I think you want to take a step back and think about your time horizon for that money. If it's money that you've already identified that you don't need, money that has come out of your IRAs or 401(k)s and you don't need it, chances are you have a pretty long time horizon for that money. So, you'd want to have the money invested, chances are in some sort of equity investments; certainly broad market exchange-traded funds, or even traditional index funds can be a great option in terms of reducing the drag of ongoing taxable distributions.

If you have a shorter time horizon for part of the money or perhaps all of the money, you'd want to think about some sort of municipal bond investment, provided that you are in a high enough income-tax bracket where that makes sense for you. But those would be really the key flavors of investment types that you'd want to think about for that taxable account.

You may also think about some sort of a tax-managed fund. So, one that I often recommend is Vanguard Tax-Managed Balanced. It's actually kind of a hybrid of equity index exposure as well as municipal bonds all in one package, and it gets rebalanced in a tax-efficient way. So, that might be another idea, especially if it's not an especially large kitty and you want it to be well-diversified.

Glaser: How about 529 plans? Is that another option?

Benz: It's a great option for retirees who are planning to save for college who do not need their RMDs. It's a way to get some additional tax benefits from the money down the line. So, with a 529 you may be able to earn some sort of a state tax benefit by contributing to your home state's 529 plan, and of course, the money will enjoy tax-free compounding and assuming that you use the money for some sort of qualified higher education expenses, the money will enjoy tax-free withdrawals as well.

Glaser: How about qualified charitable distributions?

Benz: This is a great strategy. If you had 2016 RMDs that you didn't need, that ship has already sailed. You would have needed to gone through the steps to do a QCD by year end. But for 2017, this is definitely something to have on your radar, and the basic idea there is that you are letting your investment provider work directly with the charity of your choice. The idea is that the charity receives part of your distribution up to $100,000 directly. You never touch the money, so that money does that affect your income, your adjusted gross income on your tax return. So, this can be a really neat strategy. Even if you are making a fairly small charitable contribution per year, it can be something to think about doing with part of your required minimum distribution.

Glaser: And we're sitting here on early 2017, is there any reason that you should take a 2017 RMD earlier in the year, or does it really make sense to wait till the end of the year?

Benz: Well, it's a great question, Jeremy. And the important point to remember is that those RMDs are based on your balance at year end of the year prior. So, for 2017 RMDs, that RMD amount is going to be calculated off of your Dec. 31, 2016, balance. So, that's really already set. You do not have the ability to affect the amount that you take out based on your timing of that distribution. So, that's an important point to keep in mind. I think all else being equal, for retirees who are in this position of not needing their RMDs for ongoing income needs, they probably would want to take advantage of that extra year of tax-deferred compounding to kind of wait until year end, hopefully not too late until year end, but wait until toward the end of the year to be able to take advantage of maybe just a little bit more tax benefit. But truly, it's a matter of personal preference and your own need for that income. As a practical matter, most retirees are not in this position of not needing their RMDs. Most retirees are spending more aggressively from their IRAs than the government dictates that they do.

Glaser: Christine, thanks for joining me.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.