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Managing RMDs in Tough Times

Required minimum distributions can be extra problematic in a down market. Adviser Michael Lynch explains why and provides solutions for managing the sequence of returns risk they present.

By Michael Lynch, CFP

Sarah’s on a bad run. She’s an equity zealot, hates all bonds, and focuses her entire portfolio on U.S. stock. She’s 73 and is facing required minimum distributions (RMDs) based on December 31, 2021, high-water values. Down 12% on a portfolio this year, she’s months away from locking in a decline, or is she?

Michael Lynch, CFP®, is a financial planner with the Barnum Financial Group in Shelton, CT, where he focuses on his clients’ finances so they can focus on their lives. He teaches consumer-oriented financial planning courses for leading organizations, including Madison Square Garden and Yale New Haven Health Systems. He is a member of Ed Slott’s Elite IRA Advisor Group and the author of “Keep It Simple, Make It Big: Money Management for a Meaningful Life,” October 2020. You can find more articles and videos at michaelwlynch.com. He can be reached at mlynch@barnumfg.com or 203-513-6032.

Michael Lynch

She’s non-repentant, of course, as bonds are down and the real return from cash—although better than that of her publicly traded stocks—is negative as well. By March 2022, inflation had jumped to 7.9% over the last year. So even cash is a loser, as it has lost purchasing power. It’s an asset class with dim hope of ever beating inflation and taxes over the long term.

Sarah’s Predicament

The first lesson for more traditional retirees is that they should never let themselves get into Sarah’s predicament. Our current market collapse is a college-level lesson in sequence of returns risk. This big term describes the financial phenomenon of how a six-foot-tall person can drown in a lake with an average depth of four feet. There’s a ten-foot hole somewhere. He stepped in it.

For investments, the ten-foot hole is a big down year—or a consecutive sequence of smaller ones—that erodes principal while a person is taking withdrawals. It’s possible for a person with an average return of 6% to run out of money if he withdraws 6% of the initial balance each year. The reason is that early declines turn the initial 6% into an unsustainable 8% withdrawal rate. If unaddressed, the result is the dreaded running out of money before a person runs out of breath.

The key to mitigating the sequence of return risks is to have non-affected assets. These are funds in fixed accounts or more stable U.S. government-backed assets that won’t decline drastically, or perhaps even at all, when stocks get crushed. Sarah, of course, shudders at this thought. Other people will find it attractive.

Build a Buffer

RMDs are only 3.65% at age 72. They don’t reach 6% until age 84. Setting aside 20% of your money in stable assets goes a long way toward neutralizing sequence of return risk. It provides an initial five and a half years of income. Just as you need a cash reserve for emergencies while working, you need an income reserve for bad markets when retired. This buffer provides that income reserve.

It turns our Sarah has some fixed income, but it’s in a former employer’s 401(k) or 403(b) plan, not an IRA. They are taxed very similarly, but there are subtle differences in the plans’ governing rules. RMDs from IRAs can be aggregated. In other worlds, the RMDs from three IRAs could be removed from only one, provided it summed to the amount required from all three.

RMDs from employer plans can be aggregated as well, provided that they all operate under the same section of the tax code. The combined RMDs from two 401(k)s, for example, can be removed from just one. No problem. Ditto for the RMDs from two 403(b)s. The three--IRAs, 403(b)s and 401(k)s--can never cross, however.

Using an Employer Plan for IRA RMD

The first nut we had to crack was how Sarah could use the cash assets in her employer plan to satisfy the RMD from her IRAs. The former balance is small, roughly $200,000, and the latter larger, roughly $2 million.

Here’s what we came up with. Sarah’s RMD from the employer plan was $7,500. The IRA RMD is ten times the size, at $75,000. RMDs cannot be rolled over. They are the first dollars out. That’s that. Also, RMDs from employer plans cannot be used for qualified charitable distributions (QCD). Sarah must take her $7,500 and pay income tax on it.

Given that the RMD from her IRA is 3.65%, and her stable value is up in nominal terms, I devised a plan to use it for her RMD. Call the custodian, I advised, and direct it to complete a partial rollover of $75,000 into your IRA. Shortly after this cash arrives in the IRA, send it out to your checking account. I told Sarah that she will have effectively used her stable value fund in her employer plan to fund her RMD from her temporarily depreciated IRA.

Put it Back in Better Times

The reverse of this is also advisable, I told her. When the equity market rebounds, you should complete a rollover from your IRA to your employer plan. Her plan allows this, as most large plans do. Not all plans will, however. She liked this idea less, as it meant selling stocks and purchasing fixed assets. No matter. She should do it. She likely won’t.

That was Sarah’s option one. For her, the juice may not be worth the squeeze. By this I mean the benefit of not having to see stock low may not justify the hassle of moving money from the employer plan to her IRA.

Just Send Stock

The reason: She’s not living on the distributions. The only problem with taking large distributions in bad times is the opportunity cost of selling her beloved stocks at depressed prices. The remedy: distribute the shares directly to her brokerage account.

That’s right. “In God we trust, all others pay cash” may be a humorous sign at the local diner, but it does not apply to RMDs. Sarah has the option of simply distributing enough shares in kind that, on the day of the distribution, it satisfies her total value. She’ll pay no costs to buy and sell and she’ll fully participate in the expected rebound.

Add a Charity

There’s one more issue to factor into Sarah’s decision. She is charitably minded and likes to leverage the QCD strategy to fund her favorite non-profits. This strategy reduces her adjusted gross income and minimizes the amount of Medicare Parts B and D premium penalties she’ll pay under the government’s income related monthly adjustment amount (IRMAA) provision. This consideration gives her a reason to take the cash. She’s not holding onto the stock so sending it will deprive her of the rebound. She might as well send stable cash.

Ultimately, she settled on a 50/50 split between stocks and cash.

Sarah’s Down-Market Action Plan

She will roll $37,500 of the stable cash from her former employer plan into her IRA. This goes out as a QCD. She will then directly distribute $37,500 worth of depressed equity shares. She’ll get this done right away so that any increase bolsters her non-qualified brokerage account. Keeping it out of her IRA will help with next year’s distribution.

She expects that these investments will not only return to their former glory but will surpass them. She’s held tight this long, and it’s worked so far. I can’t predict markets and I never try to do so. Still, I concurred that she has no reason to go wobbly now and I endorsed her strategy.

About the author: Michael Lynch, CFP®

Michael Lynch, CFP®, is a financial planner with the Barnum Financial Group in Shelton, CT, where he focuses on his clients’ finances so they can focus on their lives. He teaches consumer-oriented financial planning courses for leading organizations, including Madison Square Garden and Yale New Haven Health Systems. He is a member of Ed Slott’s Elite IRA Advisor Group and the author of “Keep It Simple, Make It Big: Money Management for a Meaningful Life,” October 2020. You can find more articles and videos at michaelwlynch.com. He can be reached at mlynch@barnumfg.com or 203-513-6032.

Securities, investment advisory services, and financial planning services are offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to be complete or to cover every situation, and should not be construed as legal, tax, or accounting advice. Clients should confer with their qualified legal, tax, and accounting advisors as appropriate. CRN202503-2068409