What is an RMD: Required Minimum Distribution?

Sometimes Uncle Sam can be a really nice guy.  He lets you save money in tax deferred accounts such as IRAs, 401(k)s and the like.  You get to watch that money grow over the years, accumulating in value, while not paying any taxes on the gain.  Uncle Sam just waits patiently on the sidelines not collecting taxes on the earnings.  However, Uncle Sam isn’t going to wait forever, and that is where the Required Minimum Distribution comes in.

What is a Required Minimum Distribution (RMD)?

What if you never had to tap into your IRA?  What if you had enough money from pensions and in taxable accounts so that you could just let your IRA sit, unused forever?  Well then, Uncle Sam would never get his tax money would he?  He has been a nice guy up to this point, but he has his limits, he wants to see some tax revenue, and he has decided that when you turn 70.5 is as late as he is willing to wait to start to see it.

When– Once you turn 70.5 you will be required to take money out of your IRA.  The fact is many people will have already been taking money out of their IRA, and probably paying taxes and the earnings, but if you have not, you must at 70.5.   For more details I will be writing a blog post entitled “When do I have to take my RMD?”

How much – It is the minimum amount that Uncle Sam says you must take out of your tax deferred accounts (IRAs, 401(k)s and the like) each year.  The figure is based on the value of your tax deferred accounts on the last day of the year and calculated based on your life expectancy.  For more details on I will be writing a blog post entitled “How much will the Required Minimum Distribution (RMD) be?”

Why – So Uncle Sam can finally get his hands on the tax revenue which has been deferred all these years.

IRA money is for your retirement income

You are investing money in your IRAs and 401(k)s for a reason, to use during your retirement years.  For many families, they will be taking enough money out of their account each year to cover their living expenses anyway, more than the amount that they need to take out for the Required Minimum Distribution.  Especially as we see fewer and fewer pensions.   However, it is good to know the details because the penalty for not taking your Required Minimum Distribution (RMD) is quite steep.  It is 50% of the RMD amount that should have been taken but was not.

Required Minimum Distribution (RMD) blog post series

Required Minimum Distributions generate many questions so I am creating a series of blog posts to address these questions:

Annuity Planning Tax Traps

St Louis FPA meeting

This week I attended the St Louis Chapter of the Financial Planning Association meeting at which John Olsen, CLU, ChFC, AEP gave two presentations Tax Traps in Annuity Planning and Index Annuities: Looking Under the Hood.  John serves as an expert witness in the area of annuity contracts, and is an author of books and articles.  He co-authored a book, with Michel Kitces, MSFS, CFP©, CLU, CHFC, to which I often refer; The Annuity Advisor.  It has been a helpful resource because many new clients come to me with existing annuities, and every annuity contract is different.

Annuity ownership

One of the biggest take-aways that I gleaned from the session was to pay careful attention to the titling of the annuity, who owns it, who is the annuitant, and who is the beneficiary, not only to make sure that client’s wishes will be followed upon their passing, but because of the potential tax ramifications.  John shared many examples of instances where client wishes were not met, and some that had negative tax consequences.  Especially important is who’s death triggers the benefit, and to check with the issuing insurance company to see how they handle a situation when the owner and annuitant are different.  He gave examples of how different insurance companies handle the same situation in different ways.

If the owner and annuitant are the same, generally things are more straight forward, if they are different, you want to check with your insurance company to see how they handle the death of either and make sure that it follows you wishes.

Retiring Early: One way to avoid the 10% early withdrawal penalty tax

You might have heard that you need to keep your money in your retirement accounts until you are 59½ in order to avoid the 10% early withdrawal penalty tax, but did you know that if your money is in a work retirement plan, like a 401(k), that the you can take it out earlier and still avoid the penalty?

Exception to the rule

To quote directly from the IRS website explaining this exception to the 10% early withdrawal penalty tax:

“Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50”

55 and separation from service

If you wait until the year you turn 55, then leave your employer, you can take money out of your 401(k) or 403(b) without the 10% early withdrawal penalty tax.  You will still pay income taxes of course; Uncle Sam wants that part of your retirement account.  And be careful, depending on the other income you have, the amount of income taxes you owe could be even more than has been withheld, so be sure to calculate quarterly estimated taxes so that you are not caught by surprise.

If you roll your 401(k) over to an IRA rollover account, you lose this “age 55 separation from service” exception, because it only pertains to employer plans, not IRA rollovers.

50 if you are a fireman or policeman

If you are a qualified public safety employee of the state or local government, such as a police or fireman, the age is even lower – 50 years old.

Retire early?

In general most folks need to work and continue saving their money until their mid to late 60s so that they can save enough to retire.  But for those that have been strong savers and have learned to live well beneath their means, an early retirement is a possibility.

For a lot of folks who retire as early as 55, they have resources besides retirement accounts that they tap into, for example; from the sale of a business or money they have put into regular brokerage accounts over the years after they put the maximum contributions into their retirement accounts.  If you don’t have money in non-retirement accounts that can get you through to age 59 ½, then the “age 55 separation from service” exception might be the solution for you.

Run the numbers

Only in a few situations would it make sense to tap into the retirement accounts as early as 55 years old.  One situation that comes to mind, is in the case of someone who has maxed out their contributions in their work plan since the time they started working, and they have a balance in their current employer’s retirement plan that is large enough to live off of for a four or more years.  They have run the numbers and have enough retirement assets to live off of, however they do not have enough in non-retirement accounts to live off of until they turn 59 ½, perhaps due to putting kids through college or paying off the mortgage.

Really check your numbers to make sure that you can afford to retire at 55, taking the impact of inflation into account.  Inflation has a significant impact on retirement planning.  Consider that starting to spend down your portfolio at such a young age, when you could easily live another 35 or 45 more years could jeopardize your financial future.   However, if once you have done the analysis you can afford to retire early, then you deserve to enjoy what you have worked so hard for and this “age 55 separation from service” exception to the 10% early withdrawal penalty tax is one way to help you do that.   

Annuity Questions Answered

So many new clients come to me already owning an annuity or several annuites, and they do not understand them or know what types of fees are in them.  I went back through my e-mails to clients and looked through the types of questions I get about annuities and thought I would answer some of them here by explaining some of the concepts around annuities.

An annuity is a product offered through insurance companies.  It is tax deferred, which means the income and earnings from the investment stay in the account and are not reported on your tax return each year.  That is the good news.  The bad news is that when you take the money out of the account, it is taxed at your income tax rate, which could actually be at a higher rate than the rate you would have paid if you hadn’t had your money invested in an annuity, depending on the type of annuity you have.  However, the tax deferral is a nice benefit.

Fixed Annuity

With a fixed annuity you get a specific interest rate for a specific time period.  Sometimes you will get a higher rate for the first year and then a lower rate for the remaining years, but you know this when you make your initial purchase.

Variable Annuity

A variable annuity offers you the opportunity to invest in mutual funds.  There are annuities that invest in multiple fund families, including index fund families.

Death Benefit

This is an insurance product, so one feature, or “insurance rider” that some of these products have is something called a Death Benefit.  Sometimes the Death Benefit value can be more than the Account Value.  Each product’s Death Benefit works differently.  Sometimes it is as simple as saying the Death Benefit is the greater of current market value or what you invest minus withdrawls.  Or it might have a Step Up feature.  For example each year on the anniversary of the purchase date the value is recorded and the highest annual value or current market value is the Death Benefit if you pass away.

1035 exchange

One nice benefit to this type of product is that you are allowed to move from one insurance company to another without any tax consequences.  Doing this is called a 1035 exchange (that is the IRS name for the procedure of moving the money, it seems like they put code numbers in the names of all of their procedures).  If you cashed the money in you would have to pay taxes on the gains.  If you just move it to another annuity, then you can continue to defer the taxes.


When looking at annuities be sure to compare fees.  Fees are quoted in percentages.  It is extremely important to convert the percentages to actual dollars based on the amount you are investing because when you do that you can sometimes see thousands of dollars of difference in fees between two annuities that when just looking at percentages seem to be pretty similar in fee structure.  I would always rather see my clients with that money in their account rather than give it to an insurance company unnecessarily.

Surrender charges

A surrender charge is a fee you pay the insurance company if you take your money out in the first few years after you have had the annuity.  A seven year surrender charge schedule is very common, for example the first year surrender charge would be 6%, the second year would be 5%, and so on until the surrender charge went away.  You might be surprised to know that there are annuities that do not have surrender charges!  So if you have an annuity and you are in the position of having to decide what to do with it, you can 1035 exchange it to an annuity that does not have a surrender charge.  Most people are not aware of that.

IRA annuity

If you have an annuity that is an IRA, you can always move it directly to an IRA, and forgo the extra layer of fees that you find in an annuity.  Things to consider before doing that: 1) are there surrender charges? 2) is the death benefit greater than the current value of the account?

Learn more about your annuity by reading the statement and the prospectus.  If you don’t have the prospectus, many of them can be found online by Googleing the product name.  If that does not work, give the customer service department a call, they will be happy to e-mail or mail you a copy of the prospectus which has the fee and investment information.

Peter Cottontail Makes A Lousy Financial Advisor!

Oh, I know he’s beloved by millions. And I can’t wait to bite off those chocolate bunny ears he will bring me on Sunday. But let’s face it; you wouldn’t want to get your financial advice from someone who puts all his eggs in one basket! You have probably heard that old adage, but do you know what it means?

Portfolio Diversification

Have you ever been in rush hour traffic and the lane you are in is practically stopped but the other lanes around you are moving faster. So you decide to switch lanes, but as soon as you change lanes, your new lane slows down and the lane you were in finally speeds up. That’s the problem with only being able to make one choice at a time, you have to pick the right one or you lose. With investments it is even trickier because there are so many different areas in which to invest. Luckily, with investments, you do not have to choose just one. You can diversify, and put a little bit of money in each area so that you are sure to be invested in the best performing area but you do not have all of your money invested in the worst performing area either.

Asset Classes

So what are these areas of investing that we are talking about? A portfolio should be diversified, or spread out, among stocks, bonds, and cash. Whether you should invest in an asset class or how much depends on your particular situation.

Depending on your situation, your stock portion can be divided up among the following asset classes:
* Large Company, United States stocks
* Mid-Sized Company, United States stocks
* Small Sized Company, United States stocks
* Developed International stocks
* Emerging Markets stocks

Depending on your situation, your bond portion can be divided up among the following asset classes:
* Short Term Bonds
* Intermediate Term Bonds
* Long Term Bonds

Portfolio Rebalancing

You have probably seen the investment pie charts, either in your work retirement plan materials or if you have an investment account, in the materials they provided you. Have you ever wondered “Why is it that everyone keeps telling me to use these darn pie charts?” Each different color of the pie chart represents a different asset class and that illustrates the diversification of the portfolio. So once you pick your asset classes and populate them with investments you are done right? Not so fast!

Annual Portfolio Rebalancing: The most important part!

The marketing materials give you the pie charts; they just don’t tell you how to use them. And that is a shame because, when used properly, in a disciplined fashion, they can take a lot of the stress out of market downturns. Here’s how.

Picture your pie chart, let’s say that your pie chart tells you that you should have 35% in Large Company United States stocks and that area of the market has had a terrific year and you have watched that portion grow from 35% to 38% to 40% to 45% in a year’s time! “Wow”, you say, “I have finally found an investment that makes money!” So human nature tells us, “Add more money to it”. But not so fast. Haven’t we all heard that to make money we are supposed to “Sell High and Buy Low”? Well, fortunately for us, the pie chart is going to help us do that. More on that in a minute.

Picture your pie chart again, let’s say that your pie chart tells you that you should have 15% in Small Company United States stocks and the market has not been kind to small companies this year. You watched your Small Company slice of pie shrink from 15% to 12% to 10%. Your first instinct might be to sell this investment because it didn’t do as well as the others. But that is not what you should do, instead, you should “Buy Low”. Without a plan, human nature makes us do the wrong thing at the wrong time.

Now that does not mean you buy a poor quality investment, speaking to the topic of diversification again when you buy a single stock it can go out of business, when you buy an investment that represents an entire asset class, such as an S&P 500 index fund, it is highly unlikely that all 500 companies will disappear at once.

Annual rebalancing is simply the discipline to evaluate the portfolio once a year to look for changes in the quality of any of the investments and then to check to see if your asset allocation (slices of pie) have gotten out of alignment over the year. If they are more than a few percent off, make some changes. Please keep in mind there may be tax consequences, unless you can make the adjustments in retirement accounts.

What Annual Rebalancing will do for you:

1) Help you sell high (the best performing asset classes) so you can take your money off the table.

2) Help you sell high so you can protect yourself if when “the bubble bursts”.  Have you ever noticed that it is often the investments that have gained the most, that end up falling the most when the market corrects?

3) Help you buy low (the underperforming asset classes), when prices are low.

4) Helps you prepare for when the underperformer rebounds.
2008 worst performing asset class was MSCI Emerging Markets -53.18%
2009 best performing asset class was MSCI Emerging Markets +79.02%

5) Removes emotion! Emotion has you selling when you should buy and buying when you should sell. But having a diversified portfolio and using a pie chart with an annual rebalancing plan will get you through every type of market cycle.