The Dynamics of Required Minimum Distributions

Yesterday, I summarized the rules for figuring your Required Minimum Distributions (RMD's) from traditional tax-favored retirement accounts. Today I will point out how you can use them to your advantage.

The first thing to notice about the RMD rules is that, all things being equal, if you take distributions from your IRA strictly based on the minimum required amount, you will receive a stream of increasing distributions. There are two reasons for this.

The first reason is that while the divisors that determine your required distributions are grounded in your life expectancy, they do not shrink by one each year as your real life does. The actuarial profession gives you a bonus for surviving a year. Say “thank you” to nice Mr. Actuary. So the divisors shrink by about 0.9 each year. (Actually, the divisors have been determined by the IRS based on the joint life expectancy of you and a hypothetical person who is ten years younger than you. You don’t really need to remember that. It’s just a fun fact to know and tell.) Here are the first four divisors to give you a feel for how this works:

Age 70, Divisor 27.4
Age 71, Divisor 26.5
Age 72, Divisor 25.6
Age 73, Divisor 24.7
Etc.

The second reason your RMD's tend to grow each year is that the rule for determining your required distributions has been formulated without regard to the expectation that your account will grow with investment earnings. So investment earnings—assuming we start getting them again—will make your next year’s RMD bigger than this year’s.

While your RMD’s tend to grow—and the expectation is that they grow faster than inflation—your real life living expenses might be expected to only grow with inflation. So you might be tempted to take greater retirement account distributions than the RMD rules dictate. Remember, the rules only dictate a required minimum; you are always free to take more.

Not so fast, Kowalski. If you also have an ordinary taxable investment account, all things being equal, you may realize a long-term tax saving by taking only the minimum required amount from your tax-favored retirement account, and spending a correspondingly greater amount from your investment account. I’m not talking about giving Future You a greater spending allowance than Present You; just playing with which Savings Bucket your allowance comes from. In February 12’s post I called that Spigot Planning—opening and closing the spigots on your various Savings Buckets.

Here’s an example. Jerry and George are two friends who are identical in every way—same age (age 70), same savings, same investment approach, everything. Both have two accounts—a $500,000 traditional IRA and a $500,000 taxable investment account; so each has $1,000,000 in the aggregate. But there’s one difference. George chooses to take his retirement spending proportionately from each of his accounts, while Jerry initially takes only his Required Minimum Distribution from his IRA (at least until he’s exhausted his investment account). Applying reasonable assumptions, George projects that his $1,000,000 will provide him with annual after-tax spending of $47,388 (increased by inflation each year) before depleting his wealth at age 100. While Jerry projects annual after-tax spending of $47,546. Just by engaging in a bit of Spigot Planning, and taking advantage of the back-loading allowed by the RMD rules, Jerry can increase his spending by 0.33%.

Hey. Why not? Little things add up. More on this tomorrow.