From the Mailbag: The 4% Rule, RMDs and You

Last month, we explored popular criticisms of the so-called “4% rule” and whether it is reasonable to expect to withdraw 4% of your starting portfolio value annually, adjusted for inflation, without running out of money too soon. Many pundits argue this math no longer holds up because of today’s low interest rates. But as we explained, that objection falls apart when you stop conflating portfolio income (e.g., bond interest and stock dividends) with cash flow (money you withdraw). Instead, we think you should focus on total return (price appreciation plus dividends and interest) and building an asset allocation targeting the long-term return you need over time to sustain withdrawals should suffice (provided your needs aren’t excessive). One reader responded with a question we reckon many of you share: What about required minimum distributions (RMDs) from an IRA? What if all my savings are in qualified retirement accounts and the IRS forces me to withdraw funds above and beyond both the 4% rule and my living expenses? How do I avoid depleting it too soon?

First, before we go any further, we should be clear: RMDs are suspended for 2020. So nothing we say here needs to apply to this calendar year—it is more about what follows, assuming RMDs return in 2021 (which seems likely to us).

In our view, there is a way around this. If your RMDs exceed your living expenses (and for those older folks with decent-sized IRAs, that isn’t uncommon), you can keep any excess invested. The IRS mandates only that you take the RMD out of the tax-deferred environment so they get their slice in the form of ordinary income taxes. They don’t tell you what to do with it. So if you don’t already have a plain old taxable brokerage account (e.g., an individual or joint account), you can open one at your custodian of choice and move any unneeded RMD funds there.

You can accomplish this a few different ways, depending on what is right for you and your unique situation. One way: Sell enough stock in your IRA to take your entire RMD in cash, and then move surplus cash into your brokerage account and reinvest it. Another: Liquidate the portion of your RMD that you will need to live off of, withdraw it, and then take the rest of your RMD as an in-kind stock transfer from your IRA to your taxable brokerage account. There are numerous other permutations to this, like taking your needed cash flow monthly and moving the remaining amount of cash or stock needed to satisfy your RMD late in the year. (Again, not this year!)

The right course for you likely depends on how you want to build out the taxable portion of your portfolio. For some investors, it makes sense to view the two accounts as a combined portfolio, holding different stocks in each in order to maintain diversification across the entire pool. In our experience, this works best for folks whose smaller account is still large enough to avoid having concentrated positions and outsized stock-specific risk. For other investors, particularly those whose secondary account is smaller, it may make more sense to transfer cash into the taxable account and then reinvest it in something broad and diversified, like a global index fund. Not because we love passive investing or passive products, but because it is a cheap and efficient way to diversify a smaller account.

There are, of course, tax tradeoffs to keep in mind here. Money invested in a taxable brokerage account, as the name implies, doesn’t grow tax free. You will have to pay capital gains taxes when you reap a net gain from a position, although you can offset this with realized losses. You will also have to pay ordinary income taxes on interest and dividends. But you don’t need to pay income taxes on funds you withdraw. We aren’t saying this is better or worse than an IRA—it is just a different tax treatment to be aware of.

Again, the right approach for you will depend on your personal situation, including your total assets, account size, long-term goals, time horizon and cash flow needs. Our point is simply that while the taxman always gets his share, he doesn’t have full control over what you do once you pay the piper. Funds you take out of a retirement account and don’t need for immediate expenses can still be part of your overall retirement investment strategy. Enjoy your flexibility and freedom!