Investing Insights: RMDs, Healthcare Trends, and Adobe
On this week's podcast, our analysts talk about low-volatility funds, HSA plan picks, and active managers.
Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.
Susan Dziubinski: We've seen an increase in market volatility this year. As a result, some investors may be thinking about how to maintain exposure to equities yet perhaps take a little risk off the table at the same time. For some, low-volatility ETFs and funds could fit the bill. Joining me today to share three of his favorite low-volatility funds is Alex Bryan. Alex is director of passive strategies research for Morningstar North America.
Alex, thank you for joining me today.
Alex Bryan: Thank you for having me.
Dziubinski: Now, your first pick is a pretty straightforward choice in the space.
Bryan: That's right. This is Invesco S&P 500 Low Volatility ETF. This fund basically just starts out with the stocks in the S&P 500. It ranks them on their volatility over the last year, and then it targets the 100 that have exhibited the lowest volatility and weights them by inverse of their volatility, so that the least volatile stocks get the biggest weightings in the portfolio.
It does this without any limits on how big the sector weightings can be or how much turnover there can be in the portfolio. That can lead to some pretty concentrated bets on things like utilities and healthcare stocks, for example. Overall, this offers very potent exposure to stocks with low volatility, which have historically offered better downside protection than the market and have tended to offer better risk adjusted performance than the market over long periods of time.
Dziubinski: Your second idea here is also an ETF focusing on U.S. stocks, but it takes a slightly different approach.
Bryan: That's right. This is the iShares Edge Minimum Volatility USA ETF, ticker is USMV. This fund uses a more holistic approach to reduce volatility. It's not only looking for stocks with low historic volatility, but it's also looking for stocks that have historically exhibited low correlations with one another. It's attempting to create the portfolio that's expected to have the lowest possible volatility using a complicated optimization framework under a set of constraints designed to preserve diversification.
Now, this holistic approach that's focusing on the entire portfolio leads to a better diversified portfolio. It limits how big its sector weightings can be, it limits how much turnover can happen in the portfolio, but effectively the end result is similar to the Invesco fund we just discussed. It offers better downside protection and it also offers a volatility reduction relative to the broader market. I think this is a good option for investors that are looking for a core allocation to a low-volatility fund. I think the fact that it constraints its sector weighting makes it a better core holding than the Invesco fund that we talked about.
Dziubinski: Got you. Your last pick you want to talk about toady is actually mutual fund, and it takes a global approach.
Bryan: That's right. This is the Vanguard Global Minimum Volatility Fund. This fund invests in both U.S. and non-U.S. stocks. It's using a similar approach to the iShares fund where it looks at both individual stock volatility, as well as how stocks interact with each other in the portfolio. It tries to construct the least volatile portfolio possible.
There is a couple of differences here between this fund and the iShares fund. Number one, in addition to the fact that it goes global, it also hedges its currency risk as a way of further mitigating volatility. Secondly, this is an actively managed strategy, in that it doesn't track an index. That gives the managers a bit of flexibility about when they want to rebalance the portfolio, but this is still a rules-based strategy that uses a very similar type of framework to the iShares fund. It charges a competitive 25 basis points expense ratio and has also been pretty effective at reducing volatility and offering better downside protection in the boarder markets. If you are looking for one-stop shop for broad equity exposure, both to U.S. and non-U.S. stocks, I think this is a really good option for more risk-averse investors.
Dziubinski: That's great. It's a very interesting group of funds. Thank you so much for joining me today, Alex.
Bryan: Thank you for having me.
Dziubinski: For Morningstar.com, I'm Susan Dziubinski. Thanks for watching.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Healthcare expenses are one of the largest line items in many retiree budgets. Joining me to discuss five key statistics in the realm of retirees and healthcare spending is Mark Miller. He is a Morningstar.com contributor.
Mark, thank you so much for being here.
Mark Miller: Thanks for inviting me.
Benz: Mark, on your website RetirementRevised as well as on your newsletter, which is also called RetirementRevised, you spend a lot of time on various aspects of retirement planning. One of the key ones that you focus on is healthcare spending. You brought five statistics that relate to trends in retiree healthcare spending; one is projection from a group that does research into this topic: 4% projected annual increase in overall healthcare outlays over the next decade.
Miller: Well, 20 years. The forecast changes every year, right now the current projection is 4.2% annually.
Benz: So, higher than the general inflation rate?
Miller: Higher than general inflation. Interestingly, their forecast moved down a little bit this year for the next two decades from 5.4%, mostly because of moderation in the cost of prescription drugs. That might surprise a lot of people since there is so much talk out there about the soaring cost of drugs. But it depends which segment of the drug business you're talking about. You know there are lots and lots of drugs that have gone generic, the most commonly taken medications for things like high cholesterol, blood pressure, and the like that the costs are extremely low. So, more and more of that. You still have expensive new drugs coming on--biologics and the like--but that's moderating costs as a general matter. So that that was good news.
I mean, another general good news point I would make about the cost of healthcare in retirement is that much of it is insured costs, not all but a lot of it is covered under Medicare which has the effect of making these costs more predictable and smoother, which is what insurance does. That's something you can obviously keep in mind. Could you hear these very scary numbers out there about the lifetime costs will be this hundred thousands of dollars …
Benz: $270,000 for married couple.
Miller: Yeah, maybe, but you're not paying it all out at once so let's not go too far with that.
Benz: Right. Another point that I think is worth making is that they're not brand new costs; you may have paid them through your paycheck in the past, but most of us did have some healthcare costs prior to retirement.
Miller: Yeah, but like even the projections from age 65 or in retirement, some of the numbers can look quite daunting.
Benz: Yeah. Let's look at another statistic. This one really jumped out at me--48% is the amount of Social Security income that is expected to be consumed by healthcare expenses?
Miller: This is always an interesting number. This study that we're talking about comes from an outfit called HealthView Services, which has made its whole business around analyzing these issues of healthcare costs in retirement. Looking at it as a share of Social Security income is a great way to do it I think because for so many people Social Security is the key source of income in retirement. The cost of your Part B premium for outpatient services comes out of your Social Security benefit. So there is very much of a direct relationship.
The calculation here is that for healthy 66-year-old couple retiring this year, lifetime healthcare expenses will consume 48% of those benefits. They take it down the path to look at well what does it mean for healthy 55-year-old couple today and so forth. For a 55-year-old healthy couple looking down the road of retirement, the projection is that healthcare will eat 57% of Social Security benefits. For the healthy 45-year-old couple, 63%. You kind of see that there is this unhealthy trajectory going on in terms of the escalating costs of healthcare.
Benz: Right. Let's discuss a related topic which is long-term care expenses. Genworth comes out with its annual study that unpacks various numbers related to long-term care--3% growth in overall long-term care costs as of …
Miller: When you lump together all these potential services and average it out.
Benz: Okay, so…
Miller: 3% from last year to this year.
Benz: People receiving care in all types of settings.
Miller: Yeah, so a little higher than general inflation.
Benz: Let's take a look at another number related to long-term care--7% increase, this is a big one, in terms of assisted living costs?
Miller: Yeah, big one and that's triple the rate of inflation. Semi-private room, Genworth says, the average increase was 4%. We've got several that are well outside of inflation.
Benz: Before we go too much further for people who aren't steeped in the long-term care lingo, people might be confused about the difference between a nursing home and assisted living. Can you quickly unpack what the distinction is?
Miller: Different levels of care; they're often provided in the same facility. Assisted living is somewhat lighter amount of medical attention, a little bit more independence. But it's I would say, nursing home light, whereas nursing home is the most intensive services. They are often provided in the same physical setting, but just segregated.
Benz: And increasingly people want that sort of seamless transition from one need of care to another.
Benz: Mark, let's talk about those long-term care expenses. Those are higher than the general inflation rate. Any conjectures about some of the things that are driving those costs higher?
Miller: Well, Genworth conjectured about it in the study, which was interesting they turned up. One thing that they pointed to was a shortage of skilled labor that's driving up wage costs in the industry. This is based on their conversations with care providers. The labor market, as we know, is much, much tighter than it had been over some of the last decade. I suspect, this is just personal conjecture now though, that tighter immigration policy is a factor, since the significant part of the long-term care workforce is immigrant. That could be playing a role. Genworth doesn't say so one way or the other. But that would be my conjecture on it. Then they pointed also to some regulatory issues in the background that may be increasing costs for some of these facilities.
Benz: Daunting statistics overall. Can you provide any guidance for retirees who are attempting to kind of plan for some of these expenses? You mentioned that looking at those very big ticket total healthcare outlays maybe sort of counterproductive. But do you have any sort of advice on how people should approach this?
Miller: As we've discussed before the long-term care insurance market, the commercial market, is not in great shape. There has been a lot of players that have stopped writing new policies, costs have been going up in some very unpredictable ways. You wrote this really interesting column recently, I thought, about the question of self-funding or self-insurance, pointing out I think rightly that it's not really self-insurance …
Benz: If you're the only one in the risk pool, what's the point, yeah.
Miller: Yeah, that's a risk pool of one. But that self-funding is something that one can do. I think that's out of reach for most households, as you pointed out in the piece, you've got to set aside about $2 million to make this work.
Benz: Well, it depends. But, yes, given these inflation rates the numbers can inflate in a hurry if, say, you're in your 50s and you're trying to plan for costs 30 years from now.
Miller: Right. Nonetheless personal assets certainly are way to go. Some people look at their home as an asset that can be translated into funding a need of this type. You could use different types of annuities, for example, a deferred income annuity might be an appropriate way to bolster income in the out years. There is the self-funding approach.
I always say that I think long-term care is sort of the missing piece of the puzzle in our health insurance in retirement. A lot of attempts have been made to get at this. How do we do a better job of smoothing out the risk and we don't have good answers yet.
A really reasonable approach in my mind would be adding a basic benefit in Medicare that would cover just basic level of risk, and then let people add supplemental coverage to that, much as they do in Medicare with Medigap. I think actually it would be really a great move both in terms of giving people peace of mind; I think it would give a shot in the arm to the commercial side of this business, because all of a sudden you'd have this massive public platform focused on insuring against this risk. But Congress hasn't listened to me on this yet.
Benz: Mark, it's always great to get your perspective. Thank you so much for being here.
Miller: Thanks, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Billy Fitzsimmons: We recently took a fresh look at Adobe and maintained our wide moat, stable trend rating, and we raised our fair value estimate to $300 per share. Adobe has been a top performer in recent years, but we believe the recent sell-off across enterprise software in the last month makes this an attractive point of entry for this 4-star name set to grow its top line at 20%-plus next fiscal year.
As a reminder, Adobe has a few key segments, with the two largest being Digital Media and Digital Experience.
First, Digital Media is where Adobe's flagship offering, Adobe Creative Cloud, a SaaS offering where products like Photoshop and Dreamweaver, is housed. Creative Cloud is the gold standard for photographers, videographers, animators, and graphic and web designers. Essentially if you work in any creative field you need to know how to use Adobe's products.
The second business is Digital Experience, with the Flagship offering being Adobe Experience Cloud for digital marketing. Experience Cloud is composed of Analytics Cloud, Marketing Cloud, and Advertising Cloud. This is for launching multichannel marketing campaigns. If you are Nike and want to target a specific subset of the population across email, television, social media, and the web, and receive direct analytics around the engagement, you need Experience Cloud. Marketing is one pillar under the CRM umbrella and even in a very competitive CRM market, Adobe maintains dominant market share.
Lastly, while Adobe historically has not been a highly acquisitive company, the firm had two large deals this year: Magento for digital commerce and Marketo for lead management. Overall, we think both submarkets remain in land-grab mode. Estimates suggest that the aggregate CRM market in 2016 was $36 billion and it is projected to be $79 billion in 2022.
In terms of the financials, this is a name where investors glance at the P/E and balk, but you have to remember that this is a company with almost 90% gross margins and 30% GAAP operating margins. Operating margins are still expanding, and EPS has grown and will grow anywhere from 40% to 100% year over year. This is a company committed to reducing its shares outstanding; it added $8 billion to its buyback program, something of a rarity in the high growth enterprise software space.
Jeremy Glaser: From Morningstar I'm Jeremy Glaser. There's been question marks about the future of active management, but by many measures active managers are as prosperous as they've ever been. I'm here today with Russ Kinnel, he's our director of manager research, to look at this paradox.
Russ, thanks for joining me.
Russ Kinnel: Glad to be here.
Glaser: Let's start with the prosperous question. There's been a lot of talk about this rise of indexing really eating at active managers. But by lot of measures, in terms of assets, active managers are doing pretty well.
Kinnel: That's right. Today we stand at $11.7 trillion in the U.S. in actively managed funds, that's the most it's ever been, that's almost 3 times what we had at third quarter '09. And of course, the reason is that even though people are moving some money out of indexing, they are not doing it as fast as the market's going up. You have this tremendous appreciation. Even though on the one had it seems like tough times for active management, it's also a great time for active management. They are running a huge amount of money. The market's really been kind to active management.
Glaser: And even if they are managing that much money, fees are lower, they are collecting less money on that pot.
Kinnel: Fees are lower, but obviously in dollar terms they are still collecting more than they've ever collected. They are still making more profits than they ever have.
Glaser: You did talk about some of those outflows, about the moves to indexing. When you look across strategies, what percentage are in outflows today?
Kinnel: Within actively managed U.S. equity funds, two thirds of funds are already in outflows. When you think about that, that's actually pretty dark sign for active management, because we are in a bull market, things are great. Usually flows follow performance, and you've had really strong performance in active and index alike. And yet people are really bailing on their actively managed equity funds today. It's a dark sign for sure.
Glaser: So if we were to see a downturn that could get pretty ugly fast. When you look across the market, you just talked about U.S. equities, are there other parts, maybe international equity, where we are seeing active managers hold up a little bit better in terms of outflows?
Kinnel: One positive for active management is that outside of U.S. equity active management is still being very popular. If you look to fixed income and if you look at foreign equities largely they've had a lot of strong inflows. However, in the third quarter of this year we saw that pivot. In the third quarter you had net outflows of $15 billion out of international equity, $19 billion in inflows to international index funds. That’s another thing to worry about for active management because again if international is going to become like U.S. equity, all of a sudden they are facing another really big challenge as investors start to buy into indexing overseas as well.
Glaser: In some ways then, great time to be active manager, but maybe some reasons to think that the future might not be as rosy.
Kinnel: That's right. If you think about, right now the typical fund might have, say, 20% appreciation a year and, say, 10% outflows. If instead the market goes down we go from 20% appreciation to maybe 25% or 30% depreciation and the outflows are going to accelerate, so maybe go from 10% outflows to 25%, now instead of having a big victory on appreciation and some outflows, both could get worse in a bear market. There is definitely some reason to be concerned if you are an active manager.
Glaser: Russ, thanks for sharing this today.
Kinnel: You are welcome.
Glaser: From Morningstar I'm Jeremy Glaser. Thanks for watching.
Christine Benz: Hi, I am Christine Benz for Morningstar.com. As health savings account assets have grown, Morningstar has begun grading HSAs on their merits. Joining me to discuss the latest round of grades is Leo Acheson. He is director of multi-asset strategies and alternative strategies for Morningstar.
Leo, thank you so much for being here.
Leo Acheson: Of course. Thanks for having me.
Benz: Leo, you and the team took a look at HSAs from two vantage points; one as spending vehicle, so for people who want to use their health savings account as spend-as-they-go type vehicles and also as savings vehicles. You've got it all in the paper, the specific criteria that you use to judge these accounts on. But let's start with the spending vehicle, so for people who want to use their HSA as a short-term parking place. Let's talk about the HSA account that came out on top.
Acheson: There was one that really stood out, and that was The HSA Authority. It was the only plan that we looked at of the 10, that does not charge a maintenance fee. The maintenance fee is really the biggest consideration for HSA spenders, so that really makes it a clear winner in that space.
Benz: HSA Authority, if you are using it as a spend-as-you-go vehicle. How about for people who want to harness those great long-term tax benefits that come along with an HSA and use it to invest for the long term. Here again, HSA Authority looks pretty good, right?
Acheson: That's exactly right. Of the 10 points we looked at, The HSA Authority we think is the strongest for use as an investment vehicle to save for the long term. Couple of other plans were also attractive though not quite as attractive as The HSA Authority, partially due to the fees that they charge. Bank of America and Further are also good options. One thing I would note is that Further really stands out if you want to buy passive exposure, but for active strategies it's not as good of a deal.
Benz: When you are evaluating the HSAs as long-term investment vehicles, you are looking at cost of course, you are looking at investment options. What other kinds of things are you and the team looking at?
Acheson: Costs are very important consideration. We look at the quality of the underlying funds. We're able to aggregate our fund ratings at each of these plans and see how they stack up versus one another. We also look at the menu design--does the plan offer strategies in all the core asset classes and also limit overlap among some of those options. Finally, we look at the investment thresholds which essentially require investors to keep a certain amount in a checking account, before they can invest, which could create an opportunity cost. That was another factor we looked at.
Benz: It's important to note that when you and the team evaluated the HSAs, you evaluated them on a standalone basis, so for individual investors who are out shopping for HSAs, you didn't and perhaps couldn't take into account any sweeteners that employers are adding to get their employees to contribute to the HSA that's offered in house.
Acheson: That's right. The HSA offered in-house vary from one employer to the next based on multiple factors like number of employees or insurance provider. Of course seeing you might take into consideration a match that or contribution that your firm might provide. We focus on these evaluations from an individual perspective.
Benz: You say it's important for people who are offered that employer-provided HSA to really do their homework on any particularities of their own plan and the HSA offering within it?
Acheson: Exactly. I would recommend that you request information such as what are the fees, what are the interest rates, what are the investment options, and then use that information, compare it to, for instance what we have in this paper to see if you might be able to get a better deal by going outside of your employer-offered plan.
Benz: People might say well, that's awfully cumbersome to go outside of my employer-provided plan. But you say that employee should think about at least participating in the employer provided plan through payroll deductions, and then potentially do transfers. Is that how it would work?
Acheson: Exactly. Yeah, that would be the best option, to use that and then periodically transfer it over, so then you'd have two HSA accounts side by side.
Benz: Leo, great research. Thank you so much for being here to discuss it with us.
Acheson: Of course. Great, talking with you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many affluent retirees love to hate their required minimum distributions, or RMDs. Joining me to discuss timing of required minimum distributions is Maria Bruno. Maria is head of U.S. wealth planning research at Vanguard, leading a team responsible for conducting research and analysis on a wide range of retirement wealth planning and portfolio construction topics.
Maria, thank you so much for being here.
Maria Bruno: Thank you, Christine. Good to be here with you.
Benz: Maria, you did a blog post where you talked about how a lot of people really wait until they are 70 or 70 1/2 to start thinking about required minimum distributions. You actually think that thought process should start earlier. I want to get into that, but before that let's just talk about RMDs and which account types are subject to them.
Bruno: Yes, first and foremost, these are tax-advantaged retirement accounts, either traditional 401(k)s, IRAs, individual retirement plans--those types of plans where you have made contributions throughout your working years, most likely receive a tax deduction on those contributions. The accounts grow then tax-deferred, and then later in retirement when you start taking distributions, the entire balance then would be subject to income taxes.
The one thing I will add to that is Roth 401(k)s. One of the benefits of Roth IRAs, for instance, is that you don't have to take required minimum distributions during your lifetime as the account owner. But if it's within a 401(k), you still are subjected to these required minimum distributions, but the distributions are not subject to income taxes because the dollars have already been taxed and they grow tax free. I always like to bring that up, because we sometimes forget about that one aspect of an account that could be subject to RMDs.
Benz: We're seeing more and more people take advantage of the Roth 401(k).
Bruno: Correct. We are seeing the trends increase there. One option that someone can think through is to actually roll out of the 401(k) into an IRA retirement. But, some things to think about there that go into the decision-making.
Benz: But potentially rollover that Roth 401(k) to a Roth IRA.
Bruno: Right, and then it wouldn't be subject to the mandated distributions.
Benz: Good point. Let's talk about people, who are not yet retired, maybe in their 50s and 60s, looking at their enlarged portfolio balances, thinking about retirement, wondering if it's viable. Let's talk about how they can actually start to get ahead of required minimum distributions, some ways that they can actually reduce the tax effects from required minimum distributions.
Bruno: I think it's a good place to start, but it's not an intuitive place to start. Many people are contributing to their plans; they're not thinking about what's going to happen later in retirement when I take these distributions or when I need these monies, whether or not I need to take them. The way I like to approach that is really to think about tax diversification and think about how you're directing your deferrals, whether they be into a traditional 401(k) or IRA, or whether it's a Roth vehicle if your plan sponsor allows that option within the 401(k). Many do, we're seeing increasing trends there. Then the other option, of course, would be to save outside of employer-sponsored plans and taxable accounts.
To be strategic in terms of your savings, for many individuals, traditional 401(k)s or IRAs have been the mainstream. They've been around a lot longer, were much more comfortable with those. Roth IRAs really didn't enter the marketplace until about, probably the late '90s and then they become much more prolific within 401(k)s over the last decade or so. When you think about assets, more assets are in traditional vehicles than Roth. One way to get that diversification would be to channel your deferrals into the Roth option, either within the 401(k) or an IRA, and you can split it. It doesn't have to be all or nothing.
Be mindful in terms of how you're directing those dollars. Certainly, that impacts your tax situation today because those Roth contributions are not deductible. But what you're doing is creating these different account types that will be taxed differently later in retirement.
Benz: Arguably, you could start that thought process about tax diversification even earlier in your career. If you're forward-looking, think about getting your assets perhaps in multiple account types with different tax treatment in retirement.
Bruno: Absolutely, and you know we could probably spend a good bit of time talking about Roth IRAs and 401(k)s for young investors. There's many benefits to that. But certainly as you get closer to retirement, you want to look at basically how are you allocating--we talk a lot about asset allocation but tax diversification is the same notion. You are diversifying around the direction of future tax rates. It's creating these different types of accounts that give you flexibility later in retirement.
Benz: Let's talk about someone who has already retired but isn't yet subject to required minimum distribution. So they're not yet 70 1/2. You and I have talked about this before. You've called it the retirement sweet spot. Let's talk about some opportunities that exist for people at this particular life stage.
Bruno: It's good, and I think to use the word opportunities is very strategic, because we can talk about guidelines, but how we personalize that is very individualized. The thought is, many investors during this phase, they maybe in a lower income tax bracket, maybe they are partially retired, fully retired, they may not begin taking Social Security. Their tax rate may be relatively lower. It may seem intuitive, but here is actually a good time to actually think about accelerating income to create that tax diversification. You could really do it in one of two ways. One is you can take distributions from these traditional deferred vehicles ...
Benz: So, start taking them before you're required to.
Bruno: Yeah, absolutely. They would be subject to income taxes. Pre-59 1/2, you may be subject to penalties as well. But if you're retired in that zone then if you need to spend from your portfolio, then maybe look to these tax-deferred vehicles. Yes, you are accelerating an income tax liability, but if you're going to be very surgical about this, you can be strategic in terms of maxing out the bracket. By that, I mean, there are different thresholds for tax brackets, and making full use of those low brackets while you can.
The other thing that individuals could consider is doing a series of partial Roth conversions. Tthat's a different way to create tax diversification, if you are entering retirement and feel you don't have that. Basically what you are doing there is taking a withdrawal from the traditional vehicle and converting it into a Roth vehicle. You are subject to income taxes on the pre-tax balance of the account, but then the account would grow tax free.
Benz: One reason you look at this sort of pre-RMD, post-retirement period is that in that maybe five-year window, or whatever it might be, the retiree has a little more latitude to control income in those years than once those RMD start happening?
Bruno: Yes, one they become a reality at age 70 1/2 you're fairly limited as a retiree because you are subject to those distributions. We can probably talk about some strategies there, but really being proactive to manage those accounts types earlier is, for many individuals, tax-smart. But you want to be thoughtful because if you either distribute too much or convert too much then you could be bumping yourself into a higher tax bracket. With a little bit of planning, though, you can manage that.
The other benefit as you are basically lowering your IRA balance or your 401(k) balance and then that results in potentially lower RMDs down the road as well.
Benz: Let's talk about the person who is 70 1/2. Those RMDs have started, it sounds like they've lost some tools in their tool kit that maybe they could have taken advantage of earlier in their lives. But let's talk about some strategy that people can add around required minimum in distribution. I know the qualified charitable distribution as a very popular maneuver among a lot of retirees I talk to. Let's start there.
Bruno: There are couple of things. One is the actual calculation itself as we've talked about is fairly simple. There is a life expectancy that the IRS provides, you calculate the RMD based upon the prior year-end balance. That designates the amount that you must take in terms of distribution; the penalty is pretty steep if you don't meet that. Taking the RMD first and foremost is important. How you do that--one, would be is if you're charitably inclined the QCD, which is a qualified Charitable distribution, basically the RMD is made payable to a qualified charity. For instance, here at Vanguard if we're the trustee of the IRA would instruct Vanguard to take the – it's actually it's up to $100,000.
Bruno: And that's per account owner. So, a married couple actually can do $100,000 each. Now granted those are probably decisions for higher net worth individuals, but there is flexibility there, and basically the distribution is made payable directly to the charity. So the account owner never really takes ownership of that RMD. The nice part about that is when you actually file your tax return, you designate it as a QCD and it doesn't factor into your adjusted gross income at all, it's basically taken off the top. So there is benefits to that from a tax standpoint because oftentimes we think about marginal tax rates, but we don't necessarily think about what that adjusted gross income triggers. By that what I mean is whether or not Social Security maybe taxable, for instance. Social Security benefits may be taxed at 0%, 50% taxable or 85% taxable depending upon different income thresholds. That could also increase the marginal rate.
The other thing to keep in mind is that Medicare Part B premiums are based upon income levels as well. So, if you're increasing your income it triggers not only the tax rate increase, but all these other hidden taxes potentially in the way of higher premiums or Social Security that's taxable.
Benz: Another thing, it sounds like that would burnish the appeal for the QCD is that you may not be itemizing your deductions any longer now that we have the new higher standard deduction. It seems like this maneuver might be even more attractive than perhaps in years past.
Bruno: That's actually a really good point, because if you take the QCD approach, it's not factored into the incomes and you can't take the offset charitable deduction. But because the deductions have increased, we're probably seeing more individuals who are taking advantage of the standard deduction and may not be able to itemize. It's kind of a win-win if you think about it from that perspective.
Benz: How about any other strategies for people for whom RMDs have already commenced? The QCD sounds like a good one. Are there any other things that they should be thinking about?
Bruno: There is always the case of how to take the RMD. I know I need to take this, but how do I take it?
Benz: How, when throughout the year, end of year that whole thing?
Bruno: Great, yes. So it's a good point. One would be from which accounts do I take it from. I always like to encourage retirees to think about it as a rebalancing opportunity. Take a look at the portfolio, pair back on areas where you may be overweight, most likely it's stocks given where we are with the stock market. Take strategically is a way to rebalance the portfolio back to its target asset allocation. So that's one strategic way.
The other would be, how do I take it. Do I need to take it one lump sum, throughout the year, and it really doesn't matter. What I would encourage individuals to do is to take a look at their spending account, really, their emergency reserves and see whether or not they would need to replenish that. Oftentimes at the end of the year or the beginning of the year is a comfortable spot or you could take it quarterly or throughout the year. It's pretty flexible in terms of how you can take that distribution.
Benz: Maria. Always great to hear your insights. Thank you so much for being here.
Bruno: Oh, thank you, Christine. I enjoyed it.
Benz: Thanks for watching. I am Christine Benz for Morningstar.com.