Spending Your Nest Egg Might Be Trickier Than You Think

Taking minimum distributions may not be the best move for retirees

Financial adviser meeting with clients
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Corrects the last paragraph to clarify that the investment manager’s advice applies to when your heirs are in a higher income tax bracket than you are. Story was originally published on Sept. 14.

You may have thought saving for and growing your retirement fund was the hard part and, once you’ve retired, all you have to do is sit back and spend it. But that may be easier said than done, according to a JP Morgan Asset Management study.

By law, people have to take a required minimum distribution from retirement accounts each year beginning at age 72, in most cases. You can withdraw money before that, but 80% of account holders do not, JP Morgan found in its study of 31,000 people approaching and entering retirement between 2013 and 2018. 

Key Takeaways

  • Most retirees are only taking the required minimum distribution from retirement accounts, JP Morgan Asset Management found in a study.
  • That means many of them are probably leaving too much money on the table at the end of their lives, the study said.
  • To optimize their funds, people should set retirement goals, taking into account needs, goals, risk, and taxes, financial planners say.

Of those who were at least age 72, around 84% took only the minimum required amount, known as an RMD. That resulted in people generating more income later in retirement and possibly even leaving a sizable account balance if and when they reached age 100, showing how inefficient it is to tap your nest egg this way.

Retirement planning can be tricky, because no one knows how long you’ll live or whether you’ll need medical or assisted living care—expenses that can add up quickly. Without steady income from work, people tend to continue saving during retirement, just in case. Instead, experts say, they should aim to actively withdraw from their retirement funds based on their spending plans and of course, tax efficiency.

“Once retirement is under way, in order to meet regular consumption needs a more flexible, dynamic approach to withdrawals—one that supports the actual spending behaviors—can be more effective than simply taking RMDs,” JP Morgan said in its report.

Drawbacks of an RMD-Only Approach

The first thing to understand is the goal of the RMD. Hint: It’s not about your well-being.

“Mandatory distribution is to make sure the money comes out of accounts and taxes are paid,” said Rebecca Hall, chief executive officer of RBH Global Partners, a practice of Ameriprise Financial Services. “Without them, then people who don’t need the money wouldn’t take it out and pay taxes on it. This forces the money out and then, the taxes get paid. These accounts have been protected their entire lifetime from taxes, so the government wants the taxes.”

RMD amounts withdrawn from traditional IRA, SEP IRA, SIMPLE IRA or retirement plan accounts, which have never been taxed before, are taxable at the ordinary income rate. RMD money from an account established with after-tax money, such as a Roth IRA or Roth 401(k), is not taxed upon withdrawal. (RMDs are not applied to Roth IRAs until the owner dies, but they do apply to Roth 401(k) accounts starting at age 72 like other accounts. Only the beneficiary of a Roth IRA is required to take minimum distributions.)

Additionally, RMDs are not calculated based on your personal situation. Instead, they are generally calculated by dividing each account balance by a life expectancy factor published in tables by the IRS. Typically, the RMD works out to be a single-digit percentage of total assets. For example, the annual RMD for a $100,000 account for a 73-year-old would be about $4,050. 

Considering Goals and Risks

Setting goals and planning around them is a smarter way to go than relying on RMDs, according to financial planners. 

“People tend to do well when they manage their money based on their goals, time horizon, and risk tolerance,” the JP Morgan study said. “Meeting those goals, if applicable, should not be left to chance, dependent on what is left over after RMDs are taken. The assets should be managed more proactively.”

That means figuring out what you need, what you expect your spending to be, and when the optimal time may be to take withdrawals to avoid high tax bills.

“We believe the most effective way to withdraw wealth is to support actual spending behaviors, as spending tends to decline in today’s dollars with age,” JP Morgan said. “Unlike the RMD approach, reflecting actual spending allows retirees to support higher spending early in retirement” and avoid leaving a large nest egg at the end of life.

When To Draw Down

People may also want to consider drawing down some of their retirement savings even before RMDs kick in. “Think about the transition from taxable income to no income in retirement, before Social Security kicks in, when you go from having employment income to no income,” Julie Virta, senior investment manager at Vanguard, said. “People may want to take advantage of that time to take money out when your tax bracket may be lower.”

Once you hit 70 ½ years old, you can also contribute up to $100,000 per year from your IRA directly to a charity and avoid paying income taxes on the distribution. “If you’re already giving to charity, this could be good for your planning,” Virta said. Before age 70 1/2, you would have to take a distribution, pay tax on it, and then donate the amount to the charity.

And if you are nearing the end of your life and still have a cushy nest egg, you can leave some of your retirement savings to heirs. 

But “you’ll want to think about it strategically,” Virta warned. “IRA assets aren’t always the ones to leave them. You will want to leave them a tax-efficient portfolio because dollars, when taken out of an IRA, will be taxed at the heir’s ordinary income rate.” 

She suggests considering converting the IRA to a Roth IRA, which isn’t taxed at withdrawal, or putting retirement savings into a taxable account, if your heirs are in a higher tax bracket than you are.

Have a question, comment, or story to share? You can reach Medora at medoralee@thebalance.com