If you have a traditional individual retirement account (IRA) or a regular 401(k), you can’t leave your money untouched in your account forever. Once you turn 72, you need to begin taking the required minimum distributions (RMDs) every year.
For Uncle Sam, these distributions provide a chance to harvest taxes on your retirement earnings. For you, RMDs provide retirement income, not to mention a tricky dilemma about which assets you should sell off to fund the required distributions.
Thankfully there’s a good solution to the RMD dilemma: Use them as a portfolio rebalancing tool. Done right, this approach lets you appease the IRS and decrease your risk exposure—especially in down markets.
What Are RMDs?
The IRS requires nearly all non-Roth retirement account holders to begin withdrawing a minimum amount of money on an annual basis once they turn 72. Remember, traditional tax-advantaged retirement accounts only delay taxes on your investments—the government eventually gets its share via RMDs.
Each year, you must withdraw the proper amount of RMDs by Dec. 31. It’s up to you whether you want to take the distributions in several staggered payments or one lump sum. But failure to withdraw the correct amount comes with steep penalties: The IRS will tax the amount you don’t withdraw at a 50% rate.
Since you must take RMDs, there are strategies to help optimize the impact of distributions on your finances—even after the money leaves your retirement account. One such strategy is to use distributions as a tool to bring your portfolio’s asset allocation back in line with your targets.
How to Use RMDs for Portfolio Rebalancing
Using RMDs as part of your portfolio rebalancing strategy isn’t terribly complicated, but you need to plan ahead to make it work well.
“If you’re taking your RMD at regular intervals, you have the opportunity each time you take a distribution to rebalance by selling from holdings that have appreciated more than others and get back to your target asset allocation,” says Kate Redden, a certified financial planner (CFP) with Merit Financial Advisors.
Say you’ve built a portfolio that targets a 50% U.S. equity allocation, 10% international equity, and 40% bond allocation in your traditional IRA. If the U.S. stock market is booming, international stocks are down and bonds are flat, the actual asset allocation in your IRA might shift to something like 52% U.S. stocks, 9% international equity and 39% bonds.
“When it’s time to take a distribution, only sell from the U.S. equity portion and bring your account back to the right asset allocation,” Redden says.
What About Rebalancing During a Bear Market?
During some bear markets, like 2022’s not-so-banner year for stocks and bonds, all asset classes might decline in value at the same time. This poses another dilemma for retirement investors using RMDs to rebalance their portfolios. Which assets should you sell when they’re all losing ground?
Here’s the truth: Even in a situation like this, not all asset classes decline by the same percentage rate. Using your RMDs to rebalance during down markets lets you decrease your exposure to asset classes that are declining more than others and return your portfolio to balance.
When Should You Rebalance with RMDs?
You can use the required minimum distributions at any time throughout the year. Deciding when to rebalance your portfolio with RMDs comes down to the question of whether you need the money for living expenses or not.
Rebalancing with a Monthly or Quarterly RMD
If you need the money to fund your regular living expenses, you should schedule monthly or quarterly distributions. According to Redden, the number one mistake she sees when it comes to RMDs is not planning ahead.
“An RMD is a distribution that we all know is coming, and we need to plan for it like we would any other distribution,” she says.
Generating a regular stream of RMD income offers distinct advantages. First of all, it’s easier to budget when you establish a periodic schedule of smaller payouts.
Your portfolio also benefits from frequent distributions, as it gives you and more fine-tuned control over the rebalancing process. It allows adjust your risk exposure, an approach that’s especially valuable in volatile markets
Rebalancing with an Annual RMD
If you already have plenty of retirement income and don’t need the RMD cash for living expenses, opting for a single lump-sum annual distribution makes the most sense. Then the question is what to do with the money.
One option is to stash the funds in a savings account with a high annual percentage yield (APY). If you don’t have one already, the best online savings accounts are currently offering rates of 3% APY or above. While that barely helps you keep up with inflation, the FDIC-insured savings account offers plenty of security and great liquidity.
It might sound counterintuitive, but you might also consider reinvesting the money in a taxable brokerage account. You can keep the funds at work in the market, and for investors who already maintain a separate taxable investment portfolio, these funds can also aid in the annual rebalancing process.
“One hypothetical would be to sell assets in your retirement account to rebalance that portfolio and meet your RMD requirement,” says William Bevins, a Nashville-based certified financial planner. “Then, you can deposit the funds in your taxable account, buying assets that help restore that portfolio’s proper asset allocation.”
Consider a Qualified Charitable Contribution
If you need to take the required minimum distributions from a traditional IRA, consider making a Qualified Charitable Contribution (QCD). This allows you to avoid income taxes of up to $100,000 in distributions that count toward your annual RMD amount.
There are a few rules involved. The funds must be transferred from your IRA custodian to a qualified charity. You can ask your custodian to issue a check payable to the charity. You cannot have the money distributed to your account and then send it to the qualified charity—in that case, it would be treated as taxable income.
Elyse Foster, a CFP with Harbor Wealth Management, says you should always ensure charities receiving your QCDs cash your checks. If they don’t—or don’t cash it by Dec. 31—you could get dinged by the IRS for not taking your full RMD for the year.
The $100,000 annual limit applies to all QCDs made to one or more charities from a single IRA. Joint tax filers may each make up to $100,000 in QCDs from their own IRAs. Eligible accounts include traditional IRAs and inherited traditional IRAs—Roth IRAs are also eligible, but they’re not subject to RMDs.
Once you determine the amount of your RMD for the year, you can make donations to qualified charities in the amount of your RMD for the year (or more)—all at once or in installments over time.
When using annual rebalancing with RMDs, it’s always wise to revisit this strategy in the year ahead to see if you’d be better served by switching to a monthly or quarterly strategy in the coming year.
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By E. Napoletano
Published December 12, 2022