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Smart IRA withdrawal strategies

Knowing your income needs and options is key to avoiding costly mistakes.

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Every year, if you’re age 70½ or older, you generally need to withdraw a certain amount of money from your traditional IRA, 401(k) plan, or other workplace savings plan. These minimum required distributions—known as MRDs or RMDs—are usually taxed as ordinary income. (Part of these distributions may be nontaxable if you've made after-tax contributions to these accounts.) 

It’s important to determine how they fit into your overall retirement income plan, especially if you need the cash flow to cover expenses. While the IRS requires you to take MRDs, you have some flexibility on timing and what to do with the money. For instance, if you don’t need it for living expenses, you may want to give it your heirs or a charity.

“Building a sound retirement income plan—one that can match your income sources with your expenses—is a critical component in achieving overall financial success during retirement,” says Ken Hevert, Fidelity vice president of retirement products. “Making the best use of your savings and distributions can help avoid costly mistakes. And if you don't absolutely need the money, you can make some decisions about the best way to use it."

Here are four key questions that can help you come up with an MRD strategy.

1. Do you need the money to cover living expenses?

“If you’re planning to spend your MRDs, one big consideration is managing your cash flow,” explains Hevert. “You may want to consider arranging to have payments sent directly to a cash management account that provides flexible access to the money with features such as checkwriting, ATM use, and online bill payment.”

Arranging to have the money automatically distributed to a cash management or taxable brokerage account also helps to ensure that your MRD requirement will be met by the deadline of December 31 each year, avoiding an IRS penalty on distributions made after the deadline. When planning your budget, bear in mind that you’ll generally owe income tax on any MRDs and other distributions from traditional retirement accounts. You can have taxes automatically withheld from your MRDs. If you choose not to do this, make sure you set money aside for tax time.

There are a few different “automatic” withdrawal methods that you may want to consider to help you satisfy your MRD requirement:

  • IRS recalculation method: This is the required method of calculating your MRD according to IRS rules. It generally requires annual distributions1 from your account based on your life expectancy, and is recalculated each year.
  • Purchasing an annuity: The purchase of an annuity can help turn your IRA assets into a stream of income payments, guaranteed for life.2,3 (Important note: This method does not guarantee that you will comply with the IRS MRD regulations or meet your MRD obligations. Only the amount of money being annuitized will be counted as your MRD.) This guarantees a set payment option for retirement income, regardless of your life expectancy,4 and helps reduce your risk of a budget shortfall. In addition, it provides more income beyond life expectancy than other options.5 There are two options to consider when deciding whether the purchase of an annuity may be right for you and your retirement income plan:
    • Fixed payment option: Lifetime payments remain level, and access to additional principal withdrawals is limited.
    • Variable payment option: Lifetime payments vary over time, based on performance of the underlying investments you choose. In some cases, additional withdrawals after purchase may be allowed.6

2. Do you plan to reinvest the money?
If so, you may want to consider having any MRDs routed to one of your nonretirement accounts, where you can invest the money according to your goals, time horizon, risk tolerance, and financial circumstances.

If you invest your MRD in a taxable account, you may want to consider owning tax-efficient securities to help minimize your tax liability:

  • Municipal bonds and municipal bond funds pay income that is free from federal income tax and, in some cases, from state and local taxes (note that income from some municipal bonds and mutual funds is subject to the federal alternative minimum tax).
  • Stocks you intend to hold longer than a year that may pay qualified dividends. Sales of appreciated stocks held more than a year are taxed at lower long-term capital gains rates. Just be sure any dividends the stock pays are qualified. Qualified dividends are taxed at the same low rates as long-term capital gains, but nonqualified ordinary dividends, such as those paid by many real estate investment trusts (REITs), are taxed at ordinary income rates.
  • Equity exchange-traded funds (ETFs). The unique structure of many ETFs investing in equities may help investors by allowing them to delay realizing taxable capital gains.
  • Tax-managed and other tax-efficient equity mutual funds, such as index funds, trade infrequently and may use other techniques that seek to minimize a shareholder's tax liability.
  • Finally, another option for investors with a time horizon of 10 or more years is a low-cost, tax-deferred variable annuity, which allows potential earnings to grow tax deferred until withdrawn.

Meanwhile, you may want to consider investing the existing assets in your IRA or other retirement plan in investments that are not, or are less, tax efficient, such as taxable bond funds, REITs, or short-term stock holdings. Whether you invest the money for your own purposes or for someone else's education, be sure to allocate the money according to investing fundamentals.

Say you want to use the assets to help pay for college costs for a family member or friend. In this case, you can arrange for your MRDs to be deposited directly into a 529 college savings plan, although this will not avoid the tax due on the MRD. A 529 college saving plan helps to shield any future earnings from annual taxes, and withdrawals are tax free as long as they're used for qualified higher-education expenses. Read ViewpointsABCs of 529 college savings plans.

"Know what the purpose of the money is, how long until you'll need it, and how much risk you're willing to take—and invest accordingly," says Hevert.

3. Do you plan to pass assets on to your heirs?
If so, you may want to consider converting IRA assets to a Roth IRA. Investors of all income levels are permitted to convert traditional IRAs and 401(k) plans from previous employers to Roth IRAs.

When drawing up a will, you may want to consider your current tax rate applied to converted IRA assets versus the tax rate your heirs would pay on inherited assets. If your heirs will be in a higher tax bracket than your own, then it may make sense to convert.

The Roth IRA's absence of minimum required distributions during the lifetime of the original owner means you can leave the assets in place for as long as you live, with the potential to generate tax-sheltered growth. Your heirs will have to withdraw a minimum required distribution each year after they inherit the account, but they generally won't be taxed on those distributions, which potentially increases the value of your bequest. If you are age 70½ or older, you will have to take out any MRD amount first before you convert the remaining assets in your IRA to a Roth IRA. Note: While Roth IRAs are generally not subject to income tax, they are still subject to estate tax, so it is important to plan accordingly.

When you convert an IRA, you'll have to compute the income tax on the portion of the account assets converted. Ordinarily, the entire amount converted becomes taxable income, but if you've made nondeductible contributions to any IRA, the percentage of your total IRA assets composed of investment earnings and tax-deductible contributions is determined and applied to the converted assets. When the employer plan assets are converted, the taxable portion of the conversion is determined separately from all IRA assets and from any other employer plans.

There are a number of factors to consider before converting to a Roth IRA. A conversion generally may make sense if you can pay the tax out of other savings, rather than tapping into the assets in the account you want to convert.

Another option to consider when your goal is to pass assets on to your heirs is a "dividends and interest only" strategy for spending down assets in retirement. In this case, you would invest in interest-paying bonds and dividend-paying stocks in your IRA. In some cases, the interest and dividends generated within the account may be enough to cover your MRDs, and allow you to preserve most of, if not all, the principal in your account. This method does not guarantee that you will comply with IRS MRD rules.

4. Do you want to make charitable donations now?
If so, a strategy involving a Roth IRA conversion and charitable contributions may advance your philanthropic goals while potentially enhancing your retirement account's flexibility and tax sensitivity.

The strategy involves performing a Roth IRA conversion, then making a charitable contribution in the same amount as the conversion. In general, the goal is for your donation to help reduce your taxable income by the same amount that the conversion increases it, leaving you with little or no tax impact. You could also put the charitable contribution into a donor-advised fund and distribute the money to charities over time.

For example, say you plan to convert a traditional IRA to a Roth IRA, and $100,000 of the assets in the account will be taxed. Making a deductible charitable donation from a taxable account worth $100,000 would generally offset the converted assets, leaving you with little or no additional liability.

The upshot? Your account would be converted to a Roth IRA—eliminating MRDs during your lifetime and providing tax-free potential growth7—at little or no cost and you'd advance your philanthropic objectives. Note: There are IRS limits to deductible charitable donations. Generally the limit is 50% of AGI if cash is used and 30% if appreciated securities are used.

"This move is driven by the desire to convert to a Roth IRA," cautions Hevert. "If you don't have a need for a conversion, you may be better off not converting and simply making a charitable donation."

Generally, anyone who is over age 75 and has large charitable intentions may not want to convert to a Roth IRA unless he or she is in extremely good health. Typically, the most tax-efficient asset to leave to charity at death is a traditional IRA, because the charity does not pay income tax, and the charitable bequest is excluded from an investor's taxable estate. While there are exceptions, the majority of older taxpayers with substantial charitable intentions will fall under this rule.

Whichever scenario applies to you, MRDs are likely to play an important role in your finances in retirement. Building a thoughtful retirement income plan can help you use MRDs in the most effective ways and help you reach your important financial goals. At the very least, it's important to spend some time understanding MRDs and your options, to help avoid a costly mistake.

Next steps

  • You can enroll in automatic withdrawals to manage your MRDs from your Fidelity retirement accounts each year. This service will calculate your MRD each year and distribute that amount based on your instructions. You can set up automatic withdrawals (login required) for your Fidelity IRAs, to satisfy your MRDs.
  • You can also view your MRD amount and track how much you have taken during the year by looking on the Fidelity.com "Account History" page for each retirement account. Look on the right-hand side of the screen for each account. The MRD Tracker (login required) shows the estimated MRD amount and how it was calculated, the year-to-date distributions taken from that account, and whether the account is enrolled in an automatic withdrawal plan.
  • Learn more about MRDs, including frequently asked questions.
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Before investing, consider the fund's investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus containing this information. Read it carefully.

1. Taxable amounts withdrawn prior to age 59½ may be subject to a 10% IRS penalty in addition to ordinary income tax.
2. Guarantees are subject to the claims-paying ability of the issuing insurance company. In return for a variable lifetime income benefit, the issuing company does assess an insurance charge.
3. In the event of your premature death, the issuing insurance company may provide your spouse or beneficiary with either a lump-sum payment or continued payments over the remaining guarantee period
4. Ibid., endnote 2, above.
5. Ibid., endnote 2, above.
6. Ibid., endnote 1, above.
7. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, become disabled, make a qualified first-time home purchase, or die.
ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments.
Municipal money market funds normally seek to earn income and pay dividends that are expected to be exempt from federal income tax. If a fund investor is a resident in the state of issuance of the bonds held by the fund, interest dividends may also be exempt from state and local income taxes. Such interest dividends may be subject to federal and/or state alternative minimum taxes. Certain funds normally seek to invest only in municipal securities generating income exempt from both federal income taxes and the federal alternative minimum tax. However, outcomes cannot be guaranteed, and the funds may sometimes generate income subject to these taxes. Generally, tax-exempt municipal securities are not appropriate holdings for tax-advantaged accounts such as IRAs and 401(k)s. Fund shareholders may also receive taxable distributions attributable to a fund's sale of municipal bonds.
Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry, which may affect the fund.
The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
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