Can Required Minimum Distributions (RMDs) Cause You to Overwithdraw in Retirement?
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm talking about required minimum distributions, also referred to as RMDs. And as you might know, RMD withdrawal rates can get as high as 12% of your account balance, which is quite a bit higher than even the most aggressive safe withdrawal rates that we discussed last month during the Retirement Income Series.

And these aggressive RMD withdrawal rates cause some people to worry that these forced required distributions could cause them to over withdraw and outlive their money. Now, I know this audience is smart enough to know that just because the IRS forces you to take out money and pay some taxes doesn't mean that you have to go and spend all of that money.

However, Christine Benz over at Morningstar, she wrote a great article on this topic recently, and I thought it would be a good launching pad into talking more about RMDs, how they're calculated, and how you can actually use RMDs to create a withdrawal strategy similar to something like Guyton's guardrails or the 4% rule. Let's dive in. But first, if you want to grab the links and resources from today's episode, just head over to youstaywealthy.com forward slash 125.

So in short, no, RMDs cannot cause you to over withdraw. They might cause you to overpay the IRS if you don't do any proactive tax planning during your gap years, but they aren't going to force you to outlive your money. Again, just because you're forced to take out some money out of your traditional IRA or traditional 401k and pay some taxes on that withdrawal doesn't mean that you have to go and spend all of that money. In fact, many of our clients simply have us transfer all

all or some of their RMD each year to a plain vanilla brokerage account where it gets reinvested right back into their asset allocation and back into the markets.

And really quick, just to be sure we're all on the same page here today, required minimum distributions or RMDs begin at age 72. At age 72, the IRS comes knocking on your door and says, hey, all of this money in your traditional IRA or traditional 401k, this money has never been taxed. And now it's time for you to pay those taxes. So each year, starting at age 72, the IRS forces you to take out a percentage of your account balance.

The percentage starts at a very reasonable 3.6%, but jumps to 5.3% at age 80, 6.8% at age 85, and then 12% at age 95. This percentage is determined by your life expectancy, and more specifically, the uniform life table as required by the IRS.

One interesting thing about the uniform life table, if you dig into the numbers a little bit, is that at age 72, it states that your distribution period, i.e. your life expectancy, it states that your distribution period is 26 years or until you're 98 years old. But at age 85, it says your distribution period ends at age 100. And then at age 100, it says that your distribution period ends at 106.

The reason for this, as some might know, is that study after study has concluded that the longer you live, the longer you're expected to live. And speaking of how long you're expected to live, you might also notice that the RMD Uniform Life Table suggests longer life expectancies than the Social Security Administration.

According to Social Security, the life expectancy for a 70-year-old male is 14 years versus 27 on the uniform life table used for RMDs.

At age 80, it's 8 years for Social Security and 19 years for RMDs. Now, one big reason for this difference is that the Social Security figures are based on a single life, where the uniform lifetime table used for RMDs is based on joint life expectancies. In other words, the distribution periods for RMDs are longer because they're meant to account for two lifetimes.

Also, the new formula for determining an IRA owner's distribution period makes the very generous assumption that the beneficiary spouse is 10 years younger than the account owner, even if it's not true. The net result of all of this is that the RMD withdrawal rates are actually pretty conservative given all of these assumptions that are being used.

Circling back to a comment I made earlier, using an RMD-based approach to creating a sustainable retirement paycheck is actually a highly efficient strategy to consider, according to retirement researcher David Blanchett. And that's because it ties your retirement portfolio withdrawals to life expectancy and the performance of your underlying investments.

In other words, since the withdrawal amount fluctuates each year with your age and year-end account balance, it can actually be categorized as a dynamic withdrawal strategy, which I argued last month is my preferred method for creating income in retirement. One challenge though with this approach is that your retirement paycheck will fluctuate quite a bit.

Unlike a guardrails type approach, which I talked about last week, an RMD-based withdrawal strategy will literally create a different paycheck amount every single year. That's because your life expectancy will change each year along with the balance of your account.

Depending on your asset allocation and performance of your investments, your retirement paycheck with a Guyton's guardrails type strategy might only fluctuate every three to five years. And even when it does fluctuate, the dollar amount only fluctuates by 10%.

By the way, I should have mentioned this already, but to calculate your RMD amount for the current year, you simply take your year-end account balance as of December 31st from the previous year and divide it by the distribution period on the uniform lifetime table provided by the IRS. And I'll link to that table in the show notes, which again can be found by going to youstaywealthy.com forward slash 125.

So, for example, if your ending account balance as of December 31st was $1 million and at age 72 the Uniform Lifetime Table

says that your distribution period is 25.6, you would simply divide 1 million by 25.6 and you'll arrive at an RMD amount of $39,062. So again, using an RMD approach to creating income, as you can see now, will create a different paycheck amount every single year. And this could be tricky for retirees who have a strict budget and really thrive on consistency and predictability.

Big changes in distribution amounts and withdrawal percentages can also prove to be even more challenging for people with more modest portfolio sizes. One final thing to mention here is that if you and your spouse have a very big age gap, you do need to be a little more careful if you plan to use an RMD-based approach to creating a retirement withdrawal strategy. As mentioned, the new RMD formula makes the generous assumption that your spouse is 10 years younger than you are.

But if your spouse truly is more than 10 years younger than you are, there's actually a separate life expectancy table that you have to use that takes into account both of your actual life expectancies. As Christine notes in her article, which I'll link to in the show notes,

If both partners reasonably believe that they will live longer than the average life expectancy, and by the way, just the fact that you're listening to this podcast likely puts you in the above average camp. So if both partners, both spouses reasonably believe that they will live longer than the

average life expectancy, then reinvesting a portion of the annual RMD each year as a safety net is likely a good idea. In other words, if your spouse is truly 10 years younger than you are, and you both believe that you're going to live longer than the average person, spending your full RMD each year could put you in danger of outliving your savings.

With all of this RMD talk today, I wouldn't be doing my job if I didn't remind everyone that you can and likely should take control of your RMDs before age 72, before the IRS comes knocking on your door. The primary way to do that is through Roth conversions during your gap years. Your gap years begin on the date you retire and age 70 and 72.

Age 70 is when Social Security kicks in, if you choose to delay, which can impact your tax bill. And age 72 is when RMDs kick in, which can really impact your tax bill. One of the first exercises we do with new clients is projecting what their RMD amount will be at age 72. And in some cases, when both spouses have been really good savers and each have a healthy six figures sitting in traditional IRA or 401k accounts,

Projected RMDs can get up into the mid six figures, which means you could be in a higher tax bracket at age 72 than as a working professional. And even if your RMDs aren't projected to be that high, it still might make sense to start getting money out of these retirement accounts during your gap years when income shuts off and you're in a lower tax bracket. For example, let's say you have a million dollars in an IRA account and your current tax bracket is 22%.

You or your financial planner runs a projection and determines that you're going to be in the 32% tax bracket at age 72 when your RMDs kick in coupled with social security and maybe some other income sources. So the question becomes, would you rather pay 22% on a million dollars today through Roth conversions or wait and pay 32% on a million dollar balance at age 72?

Even worse, what if that million dollars grows from $1 million to $2 million from now until age 72? Now you're paying a higher tax rate, 32%, on a higher account balance. We call this a growing tax liability. And this growing tax liability is a reason why you might still consider Roth conversions if you project your tax rate to stay the same throughout retirement.

Back to the previous example, let's say you think that you'll be in the 22% bracket forever. Well, would you rather pay 22% on $1 million today through Roth conversions or do nothing, let that account grow, and then be forced to pay 22% on a higher account balance in the future?

When I talk about tax planning and reducing your tax bill, it's not about finding some magical way to skirt around the tax rules or do anything illegal for that matter and try to pull one over on the IRS. It's all about paying taxes on your terms when it's an opportune time for you instead of waiting for the IRS to force you to pay taxes when it may not be in your best interest.

So contrary to what most people think, your RMDs are wildly important and understanding how they work, how they're calculated, and what you can do between now and age 72 to reduce them can make a giant difference in how much you pay the IRS over your lifetime and the success rate of your financial plan.

For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 125. Thank you as always for listening, and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.