( Required Minimum Distribution ) RMD: A sensible systematic withdrawal plan / easy-to-maintain retirement income planning strategy

Robert Klein for MarketWatch.com writes: Let me state up front that I don't subscribe to the traditional retirement systematic withdrawal planning strategy.  The approach to which I'm referring is the application of a fixed percentage, e.g., 4%, to an investment portfolio on the date of retirement to determine the annual withdrawal amount for the rest of your life. There are variations on this theme where the calculated amount may be adjusted for inflation and/or investment performance, however, the basic concept is the same.

Why I don't recommend traditional systematic withdrawal plans

There are three reasons why I don't use this methodology in my practice since it:

1. Typically doesn't take into consideration other non-portfolio sources of income, e.g., annuities and Social Security.

2. Usually doesn't adjust for income tax consequences of different types of investment accounts, e.g., IRA's vs. nonretirement accounts.

3. Generally doesn't allow for unusual onetime or difficult-to-plan-for expenses such as home improvement projects or long-term care expenses.

In summary, these plans are too rigid and generally aren't easy to maintain year after year for most individuals. More importantly, they don't reflect real-life needs of most retirees. People don't live on percentages; they require dollars. In addition, the dollar amounts need to be flexible.

Also see: The ‘4%’ retirement myth

The required minimum distribution plan

There's one systematic withdrawal plan, however, of which I'm a big fan. Believe it or not, it was created and is overseen by the IRS. It's known as the required minimum distribution, or "RMD," plan.

If you own qualified retirement accounts such as 401(k) plans, 457 plans, IRAs, or SEP-IRAs, you're required to take annual minimum lifetime distributions from these accounts beginning by April 1 of the year following the year that you turn 70 1/2. The amount of your distributions, or RMD's, are calculated by dividing the value of your account on Dec. 31 of the previous year by a factor from an IRS table based on your attained age during the current year.

What I particularly like about RMD plans as a retirement income planner is that the IRS table factor goes to age 115. This results in preservation of assets for unforeseen events or for a potential legacy assuming that significant distributions in excess of RMD's aren't taken.

RMD plan example
Let's look at a simple example of a hypothetical SEP-IRA account with a value of $600,000 at age 70, an average rate of return of 3%, and annual withdrawals on Jan. 1 of each year equal to RMD's. Per the spreadsheet, the initial withdrawal amount at age 71 is just under $23,000, or 3.8% of the value of the IRA. The RMD at age 80 is approximately $28,000, or 5.3% of the value of the account. RMD's exceed $30,000 and approach 7% of the account value beginning at age 85.

This is a remarkable, easy-to-maintain systematic withdrawal plan by any standards. With a relatively low average rate of return of 3%, over the course of 15 years:

• The annual distribution amount has increased by 33%, going from approximately $23,000 at age 71 to approximately $30,000 at age 85.
• The annual withdrawal as a percentage of the account value has increased by almost 80%, going from 3.8% at age 71 to 6.8% at age 85.
• Total withdrawals equal $400,000, or an average of just under $27,000 per year.
• There's still an account value of $429,000 remaining at age 85.

Since this is a SEP-IRA account and all withdrawals are taxable as ordinary income, the annual withdrawals need to be reduced by income tax liability attributable to the withdrawals to calculate the amount available for spending.

This plan by itself probably wouldn't be an effective retirement income planning solution for most people. Nonetheless, the after-tax withdrawal amounts combined with after-tax Social Security benefits could provide a nice retirement income floor.

In this example, a traditional systematic withdrawal plan approach wouldn't work. For one thing, the withdrawal percentage, assuming that it's 4%, would be less than the actual withdrawal percentages in all but the first three of 15 years. In addition, the withdrawal amounts would be less than the RMD in most years. To the extent that this occurs, a 50% penalty would be assessed by IRS on the amount not withdrawn.

Although not a traditional systematic withdrawal plan, RMD's are a sensible, easy-to-maintain retirement income planning strategy that can be used in conjunction with other income sources to provide a solid retirement income floor in many situations, preserve assets for unforeseen events, and provide for a potential legacy.