Minimum required distributions and you

Between Social Security, income from a rental property, and cash on hand, Matthew King has his living expenses covered. Yet this year he'll be required to pull $8,000 out of his IRA.

"I wish I didn't have to, since it's taxable income," he says. But he has no choice. At 75, the Miami retiree must make an annual minimum required distribution, or MRD, from his tax-advantaged retirement accounts.

An increasing number of Americans are in the same boat: not necessarily in need of more income but having to tap their IRAs and pay taxes on the proceeds. It doesn't have to be a painful process. A good income plan, coupled with the right tools, can make calculating and managing your MRD income both easier and tax efficient.

It's important to look at your MRDs within the larger context of your overall income plan in retirement, says Paul Hoxie, vice president for product development at Fidelity. "Fidelity offers a full complement of guidance tools and products to help you do everything from establishing an overall income plan to determining how and when you want to receive your MRDs," he points out.

MRDs and your income plan

Here's a quick review of MRD basics. By April 15 of the year that follows the year you turn 70 1/2, the Internal Revenue Service generally requires you to begin withdrawing money from your tax-advantaged retirement accounts (other than Roth IRAs and Coverdell Education Savings Accounts). The penalty for failure is 50 percent of the shortfall from the amount that should be distributed. Until recently, getting it wrong was easy.

"The new rules are a lot less complicated," says Ann McLaughlin, director of retirement products at Fidelity. "The IRS has eliminated difficult initial decisions and made the calculations much simpler." Of course, you should consult with your tax adviser regarding your individual situation.

Under the new rules, you simply total the value of your IRA as of Dec. 31 of the previous year, then go to one of two IRS Life Expectancy Tables to estimate the number of years you and/or your spouse will likely live to make withdrawals. (You can access these tables at Fidelity.com/goto/mrd.) The MRD calculator will yield a number based on the prior year-end IRA market value to produce an MRD amount for the year. If you choose, you can take your entire MRD from one or more IRA accounts.

Example: Assume that you are taking your MRD, and you have a $250,000 IRA and a life expectancy of 26.5 years, according to IRS calculations. The IRA's value divided by your life expectancy yields this year's MRD of about $9,430. You can aggregate this amount with the MRD from your other IRAs and withdraw the amount from any of your IRAs at any time during the year.

That said, a few sticking points remain. For one, assets from qualified plans (401(k), 403(b), or 457) can be lumped together and one withdrawal can be made.

"If you have a 401(k) and an IRA, you can't lump everything together and take money out of one account," says Jeff Feldman, a financial planner in Pittsford, N.Y. "You have to take money out of the 401(k) and the IRA."

And because tax-advantaged accounts aren't community property, a husband and wife must do their MRD calculations and withdrawals separately.

Then there's the potential impact of this new stream of taxable income on an existing financial plan. In Matthew King's case, nearly a quarter of each year's MRD goes to the IRS.

"Needless to say, I'd rather have it accumulate tax-free," he says.

Minimizing the cost of MRDs

Here are some ideas for minimizing both the complexity and the cost of MRDs when integrating them into your income plan:

Consolidate

It's fairly straightforward to calculate your MRDs and make the proper distributions, but only if you're working with complete information. Therefore, you might want to consider consolidating all your accounts with one financial institution. It's also a good idea for retirees to consider rolling their retirement plan savings from former employers into IRAs to simplify the MRD process, McLaughlin says. While a 401(k) allows for higher contributions during your working years, it may be less attractive than a traditional IRA once you retire and begin taking an MRD.

"Often you have fewer investment choices in a 401(k) than in an IRA," she points out, noting that 401(k)s, unlike IRAs, cannot be lumped together for a single MRD calculation.

IRAs also can have an estate planning advantage.

"With an IRA, a non-spouse beneficiary can generally take distributions over his or her life expectancy, potentially reducing the tax burden and continuing the opportunity for tax-deferred growth," McLaughlin says. An inherited 401(k), in contrast, is frequently required to be distributed all at once as taxable income.

Experts say you should make sure to correctly calculate the MRD for the transition year. If you roll over a 401(k) into an IRA, you're still obligated to make a final MRD distribution from the 401(k), based on its Dec. 31 balance, prior to rolling it into the IRA.

"So make the distribution, and then do the rollover," Feldman says.

Generate lifetime income

As part of your overall retirement income plan, if you are looking to generate additional guaranteed* lifetime income to help cover your essential expenses, an income annuity may be an appropriate solution. In addition to providing a stream of income guaranteed for as long as you live, the payments you receive from an income annuity automatically satisfy the MRD requirements for the retirement assets used to purchase it.

Using IRA assets to fund your income annuity is a tax-free transfer: You pay taxes only as each payment is received. You will still need to calculate your MRD income, then make withdrawals based on those calculations to meet the MRD requirements for your remaining pretax assets.

Rebalance

If your taxable accounts are mostly in bonds and other income-producing investments, the MRD inflow will raise your taxable income, perhaps even pushing you into a higher tax bracket. So, if your MRD can meet your income needs, it may make sense to shift your taxable accounts from income-generating instruments, like bonds and high-dividend stocks, to "tax-efficient" vehicles, like some growth stocks and low-fee equity funds, according to Warren F. McIntyre, a financial planner in Troy, Mich.

"These will tend to build up long-term capital gains rather than paying out taxable income each year," he says.

Check with your tax adviser before selling any assets outside your retirement plan, because you may have a taxable gain or loss on the transaction. Also, the IRS will not allow you to trade IRA investments in-kind with non-retirement investments.

The net result is more tax-deferred income in your IRA, less from your taxable accounts, and a tax bill that may benefit from the change.

"But always maintain your target asset allocation," Hoxie says. If your financial plan calls for 50 percent bonds, 40 percent stocks, and 10 percent cash-equivalent investments, for example, then shifting your taxable accounts to stocks requires a shift in your tax-advantaged accounts toward bonds to maintain the proper balance, he advises.

Use Fidelity's tools and expertise

Fidelity offers a suite of services and accounts that makes it easier to manage MRDs. These financial planning tools allow customers to create a retirement income plan and asset allocation strategy, either online or in consultation with a Fidelity representative. The plan will include an asset allocation strategy for managing your MRDs, while helping to ensure that you don't outlive your savings.

Next, consider Fidelity's complimentary Personal Withdrawal Service (PWS) on your retirement plan account (available for IRAs and Fidelity retirement plans, including Keogh Money Purchase, Keogh Profit Sharing, and Self-Employed 401(k)s), which automates the MRD process.

"Fidelity will calculate how much the MRD should be for the year and offers lots of options on how and when you receive the money," McLaughlin says.

Once you've created your income plan, you may want to consider the Fidelity Income Management Account (IMA), which can help you track and manage your MRDs--for example, with alerts notifying you when an MRD is due. The IMA also helps you consolidate income sources, manage investment accounts, and track spending and withdrawal rates.

Consolidating your assets may make it easier for loved ones to help manage your finances in the future.

"As people grow older, they may not be in a position to do all the active management they want, and this is one place where anyone taking over the reins can access everything," Hoxie says. "It's all about simplifying your financial life."

Tips for navigating the first year

If you haven't started taking minimum required distributions (MRDs), but will soon, the first year offers both opportunity and some potential pitfalls. Your first withdrawal must be taken by April 1 of the year following the year you turn 70 1/2. This means that you may not need to take the initial distribution the same year that you turn 70. If you wait to take your first distribution until the following year, you will need to take two distributions that year--by April 1 and again by December 31.

Whether it's wise to wait depends on several factors. By waiting, you keep the money compounding tax-deferred for a few more months. On the other hand, because you'll owe an MRD for the second year, as well, waiting will mean making two withdrawals in the same year, which may push you into a higher tax bracket. And because the second-year MRD will be calculated on the previous year-end total, "your second-year balance will be higher, so your withdrawal will have to be higher," says Ann McLaughlin, director of retirement products at Fidelity.

Delaying the first MRD might still be a good idea if you intend to stop working when you begin taking distributions, McLaughlin says. In that case, your taxable income might be lower in the second year, making two withdrawals less taxing.

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