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Creating Retirement Income: From RMDs to SWRs

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A reader recently asked the following question about retirement withdrawals:

I am approaching 72, and for the life of me I do not know the difference between setting a safe withdrawal rate (SWR) and how that relates to my required minimum distributions (RMD). Perhaps you can write a post someday that will explain the relationship between the two. A simplistic question I have is this: what if my RMDs exceed my desired SWR?

I often throw around financial terms (and abbreviations and acronyms) and forget how confusing these concepts can be. So I appreciate questions that show me what readers are struggling with and whether I’m simplifying financial topics for readers or adding to the confusion.

Getting Clear on Retirement Withdrawal Terminology

SWRs and RMDs are both abbreviations for terms related to taking money from retirement accounts. That is about all they have in common. I’ll first briefly define each term and then we can explore each in more depth and the relationship between them.

A RMD is the amount you must withdraw from certain tax-advantaged retirement accounts. The IRS mandates that you distribute the money from these tax-deferred investment accounts, creating a taxable event for the account holder in the year you withdraw the money.

You don’t have to spend your RMD. You can reinvest the proceeds into a taxable account that is not subject to RMDs.

SWR research is concerned with determining the amount you can withdrawal from your entire retirement portfolio without exhausting it before you die. You ultimately must determine this amount. No one can tell you with certainty what it is.

SWRs are concerned with meeting spending needs without running out of money. This information is also helpful to help determine how much money you need to retire comfortably and confidently.

What is a Required Minimum Distribution (RMD)?

RMD is a term defined by the IRS as the minimum amount that you must withdraw from certain retirement accounts each year. You must take your first RMD by April 1 of the year following the year you reach a certain age (details below). Subsequent RMDs must be taken by December 31st of the current year.

Accounts that are subject to RMDs include:

  • Traditional, SEP, and SIMPLE IRAs
  • 401(k) plans
  • 403(b) plans
  • 457(b) plans
  • Profit sharing plans

RMDs assure the government will get their share of tax-deferred retirement accounts. There are substantial tax penalties if you fail to meet your RMDs.

You deferred federal income tax when you made these contributions. When you take the RMD, the distributions are taxed at prevailing ordinary income tax rates in the year of this transaction.

The amount of your RMD, as a percentage of your account balance, increases over time as your life expectancy shortens. The amounts are determined by IRS actuarial life expectancy tables. You calculate your RMD by dividing your account balance on the last day of the prior year by the expected distribution period per the IRS tables.

A typical 72 year old would have an expected distribution period of 27.4 years. If you had $1 million in tax-deferred accounts, the required distribution is $36,496.

A 90 year old would have a lower expected distribution period of 12.2 years. On the same $1 million balance their RMD would be significantly greater, $81,967.

It is important to note that RMDs only apply to tax-deferred retirement accounts. There is no RMD from a taxable account.

You are also not subject to RMDs on Roth accounts if you are the original owner. However, there are different rules if you are the beneficiary of an inherited IRA which are beyond the scope of this post.

Recent Changes to RMD Rules

Since I originally received this reader question, RMD rules have substantially changed. The most notable changes relate to the required start age for RMDs, penalties for failing to take the RMD, and changes related to Roth accounts. Changes are generally favorable.

Beginning in 2023, the start date for RMDs increases from 72 to 73. The age is scheduled to again increase to 75 in 2033. This is a continuation of a trend that benefits those who do not need to take the full RMD amount to meet retirement spending needs. Tax advantaged money can compound longer.

Another notable change is the reduction of the penalty for failing to take your required RMD. The penalty had been 50% on the undistributed amount. New legislation reduces the penalty to 25%, which is further decreased to 10% if the error is corrected in a timely manor. Even reduced penalties underscore the point that these are required transactions designed to force you to pay tax that you had been deferring.

Roth IRA accounts were never subject to RMDs for the original account owners. However, other Roth accounts like Roth 401(k) accounts were subject to RMDs. This changes with recent changes to tax law. Going forward, no Roth accounts are subject to RMDs.

RMDs on Roth accounts could previously be avoided by doing a 401(k) to IRA rollover. However, this may have meant giving up some features of the 401(k) (or other work sponsored retirement accounts) which are preferable to IRAs. The new law eliminates the need to take this action.

Related: Should You Rollover Your 401(k) to an IRA?

What is a SWR?

Your safe withdrawal rate is a conceptual framework. People often discuss the 4% rule which was derived from Bill Bengen’s original research on SWR. 

Bengen was trying to determine the amount that you can safely take without running out of money over the course of  a thirty year retirement. The framework he modeled called for taking that same amount, adjusted annually for inflation, in each subsequent year.

He found, based on the data set and assumptions that he used, that 4% is the maximum withdrawal you could safely take across all the periods he modeled. However, his research showed that in many years the amount you could safely withdraw was substantially higher. 

Of course, there is also no guarantee that future conditions could not be worse than those in his data set. In fact, Morningstar suggested a 3.3% SWR for those starting retirement in early 2022. They have recently increased their suggested SWR to 3.8% for those starting retirement under current market conditions.

In reality, you can’t know what your personal safe withdrawal rate is until after the fact because you can not know what the future holds. No one knows exactly how long we will live, what spending needs may arise during the time we are alive, what future inflation will be, and what market conditions we’ll experience along the way. 

We can only look at past scenarios as a starting point. From that information we need to make our best estimate at what lies ahead.

For an in depth look at SWRs with an emphasis on early retirees, I highly recommend the Safe Withdrawal Rate Series at the blog Early Retirement Now.

What if your RMD > SWR?

With that foundation, let’s address our reader’s question. What if your RMD exceeds your desired safe withdrawal rate? I’ll restate the question in a different way. What if your RMD exceeds your desired spending?

First off, this is an enviable position to be in. Remember RMDs only apply to tax-advantaged retirement accounts. Many people will need the full amount of their RMDs and more to meet retirement spending needs.

There is no requirement to ever spend your taxable investments and savings. You also don’t ever have to take withdrawals from Roth accounts for which you are the original owner. Any money already invested in taxable or Roth accounts could stay invested and growing indefinitely.

Related: When Are Roth Accounts Better Than Tax-Deferred Accounts?

If you have large RMDs that exceed your desired spending, you must take the required distribution and pay the tax created by this transaction. Spend what you need, if anything, from RMD proceeds. Then reinvest any leftover amount into taxable investment accounts or put it into taxable savings accounts.

If you anticipate this scenario in advance, you could strategically convert tax-deferred accounts to Roth accounts. This may allow you to spread taxable distributions over a greater period of time, paying taxes at lower rates. Remember, Roth accounts are not subject to RMDs.

What if your SWR > RMD?

The reader did not ask this question, but this is the more common and complex scenario. What if your RMD does not meet your spending needs?

Your RMD are one source of retirement income which is taxable regardless of whether you need the income in that year or not. Others include any pension, taxable dividends and interest, earned income, as well as a portion of your social security benefits.

Since you are required to pay tax on this income, you should spend income from these sources first. Then if you need more income to meet your spending needs, you would have to assess the sources you have available to you and create that income in the most tax-efficient way.

Unfortunately there is no one size fits all answer as to the best way to do this. Factors to consider are the types of accounts you have available, the amounts in each, and the short and long-term tax impacts of your distribution strategies.

Tax software enables you to see the year-to-year tax impacts. A high fidelity retirement calculator like the NewRetirement PlannerPlus or Pralana Gold tools allows you to see the federal and state tax impacts of your strategies over time. This scenario may also be an example of where paying for financial advice has the potential to add substantial value.

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Valuable Resources

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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