For some, nothing to fear from taking RMDs, professor says

By Susan Rupe

Mass affluent clients who have the bulk of their financial wealth in tax-deferred accounts such as individual retirement accounts must take substantial required minimum distributions when they turn age 73. Some clients may dread the prospect of having to pay taxes on these distributions. But a professor and author said advisors must reassure these clients that there is little to fear from RMDs.

Edward McQuarrie, professor emeritus in the Leavey School of Business at Santa Clara (Calif.) University, presented a webinar on “Helping Clients Cope With RMDs” for the Financial Experts Network.

SECURE 2.0, passed in December 2022, raised the beginning age for taking RMDs from 72 to 73. That beginning age will rise to 75 in 2033.

When it’s time to take RMDs, McQuarrie said, clients often “come from a place of fear and resentment.”

“They’ve invested and saved for decades,” he said. “They like looking at their tax-sheltered account statements. They’ve watched the totals rise.”

McQuarrie said many affluent clients may not need to withdraw from their tax-deferred accounts every year to meet their living costs. They may have substantial income from Social Security or other sources. Now these clients are upset because they are required to take money out of their accounts each year and pay taxes on those withdrawals.

In this situation, he said, advisors must serve as counselors to their clients.

“You will have to address the fear and loathing felt toward what clients regard as the government’s smash-and-grab, this raiding of their wealth, otherwise known as RMDs,” he said. He added that advisors must show clients they have a good grasp of why RMDs exist, how the RMD schedule was derived, how RMD income grows over time and practical steps to manage the tax consequences.

One thing to reassure clients, McQuarrie said: RMDs are highly unlikely to exhaust a client’s savings during their lifetime.

The required amount to be withdrawn glides upward slowly at first, he explained. The withdrawal percentage doesn’t hit 10% until the account holder is in their mid-90s; even when they reach age 100, the withdrawal percentage is about 16%.

But RMD income is likely to go up for many years, he said. Since tax bracket boundaries only increase with inflation, the tax risk for taking those RMDs cannot be computed only once when the account holder is at age 73.

RMD income from a balanced portfolio (60% invested in equities and 40% invested in bonds) will grow faster than the rate of inflation, McQuarrie said. As a result, he said, the account holder likely will continue to have a tax risk, and is most likely to be at risk of triggering an IRMAA event. If the client already starts taking RMDs when they are in the middle or near the top of their tax bracket, they are at risk of higher income tax and a possible IRMAA event.

McQuarrie also warned of a possible IRMAA and Social Security tax torpedo.

How do you manage the RMD tax risk? McQuarrie described this as follows:

Pick a client and develop a spreadsheet projection for them. Set it up so you can apply it to other clients after you designed it. You will need to project tax and IRMAA boundaries at some rate of inflation and estimate a portfolio return and total income once RMDs begin.
The sweet spot for taking action is when the client is between the ages of 59 and 62. This is before Medicare kicks in and ideally before the client begins taking Social Security. When a client is in this age group, they generally are old enough for income and tax projections to be more reliable yet they are young enough to make corrections to the plan if needed.

One option for clients who have amassed large balances in their tax-deferred accounts, McQuarrie said, is to retire early, begin voluntary withdrawals from their accounts while delaying claiming Social Security benefits until age 70.

A second option is for clients to convert their tax-deferred account to a Roth account. McQuarrie said this conversion can be done over several years.

Clients also can donate their RMDs to charity, making a qualified charitable distribution to reduce their taxable income. A client who does not want to donate their RMDs to charity can take the RMD and invest the after-tax remainder, McQuarrie said.

In today’s ETF structure, he said, the tax burden for holding equity investments outside of any tax-sheltered account can be as little as 30 basis points annually. In addition, if the RMDs are truly surplus income to the client, a large taxable account can be built in only a few years, he said. For example, if all the client’s ordinary expenses are covered by Social Security or other income sources, and the client has $100,000 of RMD after taxes to reinvest, after four years at stock market returns, the client will have almost a half-million dollars.

To view a replay of the webinar, go to: https://www.financialexpertsnetwork.com/webinars/sessions/helping-clients-cope-their-required-minimum-distributions

Susan Rupe is managing editor for InsuranceNewsNet. She formerly served as communications director for an insurance agents' association and was an award-winning newspaper reporter and editor. Contact her at [email protected]. Follow her on Twitter @INNsusan.