RMDs May Get a Bit More Minimal

If you are presently saving for retirement in a 401(k) or IRA—or wish the small business you work for offered a 401(k)—we have some potentially good news! A recent executive order instructed the Labor Department and Treasury to consider tweaking regulations to make 401(k)s less costly to administer, make it easier for small businesses to join forces in a single 401(k) plan, and make IRAs’ required minimum distributions (RMDs) less burdensome. As with most news surrounding the Trump administration, media reaction was largely sociological, with many speculating about potential pros and cons of more widespread adoption of defined contribution retirement plans. However, we think all investors ought to be aware of the potential changes, especially on the RMD front.

IRA RMDs began in 1987 as part of the Reagan Administration’s tax reform. Until then, there wasn’t any way to ensure the IRS would eventually get its cut of Americans’ tax-deferred retirement savings. When the Employee Retirement Income Security Act of 1974 (ERISA) introduced IRAs, it established that workers would fund them with pre-tax income and pay income taxes on eventual withdrawals. But without mandated distributions, savers could theoretically sock away money forever, letting it grow tax deferred into perpetuity. Hence, the RMD, whose sole purpose is making retirees pay taxes. Once you hit age 70 ½, you take your IRA’s prior year-end balance, divide it by a number provided by the IRS, and withdraw that amount. And you do this every year until you die^[i] (or your IRA reaches $0), withdrawing a steadily larger percentage of your account.

The executive order suggests examining and perhaps updating “the life expectancy and distribution period tables.” That is quite nebulous, but one potential outcome is increasing the RMD starting age. It hasn’t changed since 1987. But life expectancies have. In 1987, the typical 65-year-old man could expect to live 15.7 more years. The typical 65-year-old woman had 19.1 years. Today, the average life expectancy at age 65 is 19.1 years for men and 21.2 years for women. For some, delayed RMDs could enable them to use other accounts to meet cash flow needs for longer while racking up more tax-deferred growth in their IRAs. It could also mean more assets in retirement accounts later in life, when health care expenses are typically far higher.

Alternatively, the Treasury could reduce the required distribution amount. Currently, the IRS computes RMDs with “divisors,” which are based on a very conservative estimate of life expectancy (or, as some literature puts it, the number of years of projected future distributions). The divisor starts at 27.4 for age 70 and dwindles to 1.9 for folks 115 or older. This IRS worksheet has the full range, though your account’s custodian and your tax adviser can probably help you with the finer points. The IRS hasn’t adjusted this schedule since 2002, when the Bush Administration was concerned the old rules made it too easy for retirees to outlive their IRAs. The new rules simplified the RMD computation by providing a uniform table and helped extend accounts’ survival, reducing required withdrawals for a 70-year old from over 6% to under 4%.^[ii] Updating life expectancy tables now would probably give retirees more flexibility and reduce RMDs (and potentially taxes), as well as further reducing the risk of retirees’ exhausting their IRAs too soon.    

It is impossible to know how this will shake out. Executive orders don’t always result in policy changes. The Treasury and Labor Department could determine that the status quo is optimal. If they opt for change, the executive order grants them wiggle room to choose between a one-time change or scheduling periodic revisions to keep up with rising life expectancies. Whatever happens, the potential for change is important to be aware of, especially for those with multiple sources of retirement cash flow. For example, RMDs may make it beneficial for some folks to take more cash flow from a taxable account than an IRA, depending on their situation, as long-term capital gains tax rates (which taxable accounts are subject to) can be lower than income tax rates (which IRAs are subject to) for some people. So keep an eye out for change, and give your tax adviser a buzz to see how new rules might affect you personally.