RMDs: A Retirement Tax Burden or Portfolio Opportunity?
After years of diligently saving for retirement, many Americans are now facing a new reality: mandatory withdrawals known as required minimum distributions (RMDs). While most retirees may instinctively view these withdrawals as a tax burden, savvy investors see an opportunity to rebalance their portfolios and strategically adjust their tax locations. As the age for beginning RMDs has recently shifted, with most retirees now needing to start by age 73, understanding how to make the most of these withdrawals is more important than ever.
Here are a few key takeaways that might spark your interest:
- RMDs aren’t just about taxes: They can be a strategic tool to improve your portfolio’s performance during retirement.
- Rebalancing your investment portfolio is achievable with RMD funds, aligning your asset allocation with your risk tolerance and goals.
- Tax-efficient asset allocation is another key strategy, with RMDs allowing for strategic shifts between pre-tax and Roth accounts.
Rebalancing Your Investment Portfolio With Your RMD
As the years go by, your investment portfolio naturally drifts away from your original asset allocation due to fluctuating market conditions. RMDs provide a perfect opportunity to rebalance and ensure your investments align with your risk tolerance, financial goals, and time horizon.
As Paul Winter, President of Five Seasons Financial Planning, explains: "Every client in my practice has a target asset allocation, so I sell a holding from whichever asset class or classes they happen to be overweight at the time."
This approach involves identifying the assets where your portfolio has grown larger than intended and using RMD funds to sell a portion of those assets, bringing the allocation back in line with your long-term strategy.
It is crucial to avoid selling investments simply because they are currently down to prevent falling victim to the sequence of returns risk. This involves selling investments during market downturns, which could mean selling more to meet your RMD obligation. Such actions can shrink your portfolio over time, leaving less capital to benefit from potential market rebounds.
Leveraging RMDs for Tax-Efficient Asset Allocation
RMDs also offer an opportunity to strategically adjust your "tax location" – the type and location of your investments, with the goal of minimizing future tax liabilities.
Here’s a breakdown of the different tax implications for various asset types:
- Pre-tax retirement accounts: Subject to regular income taxes based on your federal bracket.
- Brokerage accounts: Subject to capital gains taxes on investment growth.
- Roth accounts: Generally grow tax-free.
If you don’t need the full RMD amount immediately, you could use it to reinvest in a brokerage account. While this move might not reduce your current tax burden, future growth will benefit from more favorable capital gains tax treatment.
Imagine this scenario: You are required to withdraw $50,000 from your traditional IRA. Rather than immediately spending this money, you reinvested it in a brokerage account holding a mix of stocks and bonds. While this doesn’t affect your immediate tax liability, the appreciation of these assets in the future will be taxed at the lower capital gains rate instead of your potentially higher income tax rate.
Considerations and Additional Tips
While RMDs present opportunities for strategic portfolio management, there are some important points to consider.
- Consult with a financial advisor: A qualified professional can help you develop a personalized plan to strategically use your RMDs.
- Plan for potential tax liabilities: RMDs will often increase your income tax burden, as the withdrawals are considered taxable income.
- Understand your options for RMD distribution: You can choose to take the minimum RMD amount, or you might consider a larger withdrawal depending on your individual needs and desired tax impact.
- Don’t forget the potential penalty: Failing to withdraw the minimum RMD amount by the deadline can result in a 25% penalty.
The bottom line? While RMDs may initially seem like an unwelcome requirement, they can be a valuable tool for strategic retirement planning. By understanding how to use these withdrawals to rebalance your portfolio and adjust your tax location, you can help ensure a more comfortable and financially secure retirement.
