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Managing Your IRA in Retirement – Part 2

In Part 1 of this series, I discussed proper portfolio diversification in an Individual Retirement Account (IRA) for someone approaching age 70 when mandatory distributions kick in. Today, I will talk about withdrawal strategies.

If you are not yet familiar with mandatory distributions, that’s the government’s way of making sure it gets a piece of your retirement assets sooner rather than later. According to the IRS:

“Required Minimum Distributions (RMDs) generally are minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 70 ½ years of age or, if later, the year in which he or she retires.”

There are some exceptions to this rule, but for most folks the explanation above applies. Once you reach age 70 ½ , you must begin taking withdrawals from your qualified retirement accounts based on remaining life expectancy according to one of three methods:

  • Joint and Last Survivor – Can only be used if you have a spouse that is at least 10 years younger than you.
  • Uniform Lifetime – Must be used if your spouse is less than 10 years younger than you or is not your sole beneficiary.
  • Single Life Expectancy – Applies when you have no spouse or are the beneficiary of an inherited IRA.

Even under the least generous of these options, single life expectancy, it will be several years before the mandatory distribution amount becomes a big number. At age 70, the remaining life expectancy (per the IRS single life expectancy table) is 17 years which works out to a distribution rate of 5.9%. Five years later at age 75, life expectancy is 13.4 years which equates to a 7.4% withdrawal rate.

However, once you get into your 80s the fun really begins. Life expectancy drops to 7.6 years at age 85, for a distribution that year of 13.2%. And if you’re lucky enough to make into your 90s? By then, you will be pulling out 20% or more of your portfolio every year.

Keep in mind that just because you must take withdrawals from your IRA, that does not mean you can’t continue to invest it for future income and growth. All it means is that the IRS wants its piece of that money now, and you can do whatever you like with the rest in a taxable investment account.

Don’t Fear the (Tax) Reaper

For that reason, I do not recommend changing your portfolio allocation in an attempt to generate enough earnings each year to keep up with the mandatory distribution amounts. That may not be difficult to do while in your 70s, but over time it raises the bar so high that you are forced into making sub-optimal portfolio decisions.

Also, unless you have a lot of other taxable income at that age, the reality is that you won’t pay as much tax on it as you may think. Let’s say you are 75 years old and have an IRA worth $500,000. At the minimum mandatory withdrawal rate of 7.4%, that would result in taxable income of $37,000 on top of whatever pension and/or Social Security income you may be receiving.

Of course, withdrawals of pre-tax contributions from a retirement account are taxed as ordinary income and not earned income or capital gains, so you would pay no FICA taxes on them. Excluding any other income, the effective federal tax rate on $37,000 of ordinary income for a single taxpayer works out to nearly 13%, or roughly $4,800. So, is it worth completely overhauling a $500,000 portfolio in response to a tax burden that equates to roughly 1% of its value?

I don’t think so, and therein lies the essential point: Do not let mandatory IRA distributions interfere with proper portfolio diversification for your specific needs. Sooner or later, the tax man cometh. And when he does, politely pay him and then show him the door.

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