Many large U.S. employers offer either a 401(k) or 403(b) retirement plan to their employees. Those who are self-employed are eligible to set up a one-participant 401(k) or Defined Benefit Plan, or they can contribute to a SEP-IRA, SIMPLE IRA, or Traditional IRA. Upon retirement, 401(k) and 403(b) accounts are usually transferred to a Rollover IRA. You can leave your 401(k) or 403(b) in your employer plan, but employer plans generally have more limited investment options and higher fees than an individual Rollover IRA.
It is called a Rollover IRA because you are doing a tax-free rollover of another qualified plan into the IRA. This is different than a traditional IRA where you would make tax-deductible contributions over time. You can generally roll your qualified employer sponsored plan to a Rollover IRA any time you sever service from your employer. All these plans offer tax deductible contributions and deferral of investment income. Distributions are generally fully taxable as ordinary income both in Canada and the U.S.
The idea with qualified retirement plans is to make deductible contributions while you are working and have higher employment income. Theoretically, you will be in a higher tax bracket during your working years than when you are retired. Contributions are deductible, so you can invest 100% of your contribution to allow for maximum account growth. Your distributions are then fully taxable when you are no longer working and in a lower tax bracket.
Roth IRAs and Roth 401(k)s operate in the opposite fashion, your contributions are not deductible, and your investment income and distributions are tax-free. Roth plans are typically used early in your career while your income is still low, or during low-income years if you are self-employed or have variable compensation. Roth conversion can also be used if you retire before required minimum distributions are required. A Roth conversion is when you transfer all or part of your IRA to a Roth IRA. You must pay tax on the IRA distribution, but the remaining funds are then eternally tax-free.
The SECURE Act of 2019 became effective in 2020 and changed the Required Minimum Distributions (RMD) rules for qualified retirement plans. Prior to 2020, RMDs had to begin by April 1 in the year after you turn age 70.5. The new rules for 2020 and beyond require RMDs to begin by April 1 in the year after you turn age 72. You are required to take a RMD for the year you turn age 72. Should you wait until age 73 to take your first RMD, you will have to take two RMDs in the same year. This may result in paying a higher tax rate due to the additional income in that year.
The Internal Revenue Service (IRS) publishes the IRA Required Minimum Distribution Worksheet to help you determine your annual RMD. The RMD is a function of your account balance from the beginning of the year and the distribution period, which is based on your age. You divide your beginning balance for the year by the distribution period to determine your RMD. At age 72, the distribution period is 25.6, which equates to a distribution of 3.9% of your beginning account balance. The distribution period decreases by 0.9 or less each year so that by the time you are 90, your distribution period is 11.4, resulting in a distribution of approximately 8.8% of the beginning account balance. Assuming good markets, IRA account balances tend to grow until you are in your mid-80’s because investment gains are more than the RMD requirement. Distributions can grow significantly in your late-80’s and 90’s pushing you into higher tax brackets.
In Canada, the Registered Retirement Savings Plan (RRSP) is like an IRA in that contributions are deductible, growth accrues tax-deferred, and distributions are fully taxable. In the year you turn 71, you must convert your RRSP to a Registered Retirement Income Fund (RRIF). The Canada Revenue Agency (CRA) also publishes a chart of prescribing factors to assist you in determining your minimum RRIF distribution. Distributions also must begin in the year you turn 72, but the amount of each withdrawal is higher than with IRA RMDs. At age 72, the minimum distribution for most RRIFs is 5.4%. At age 90 the distribution is 11.92%, and it is 20% every year once you reach age 95.
If you are now 72 or older and have an IRA or other tax-deferred qualified retirement account that requires RMDs, how should you go about making distributions? Do you distribute at the beginning of each year? At the end of each year? On your birthday? How do you optimize RMDs and get the most out of your retirement savings? Here are some principles to keep in mind as you make that decision:
- Assuming positive markets, it is best to take your distribution at the end of the year to defer the investment income for as long as possible. The other side of this coin is that the larger your IRA grows, the larger your future RMDs will be. In the end, it is better to have more money even if you must pay more tax.
- Taking quarterly distributions will create a dollar cost averaging effect, which means you will get better sales prices on some distributions than others. The varying sales prices will average out in the end and lower your overall market risk. The downside to this is transaction costs increase the more distributions you have. Excessive trading may eliminate any benefit realized from the dollar cost averaging. We typically recommend either annual or semi-annual distributions to minimize transaction costs. Also, if you do not have a sufficient emergency fund, you may be forced to liquidate securities at the bottom of a market trough.
- Investing 101 is buy low and sell high. You want to liquidate as few shares as possible to create the income you need. It is best to take distributions when markets are up as opposed to at the bottom of a trough. You are never going to time the market perfectly, and we do not believe in trying to do so. It is extremely difficult, if not impossible, to consistently determine when the market has peaked, but it is much easier to tell when we are in a market downturn. In other words, if the market has done well for an extended period, we know that the rally will not last forever, and we do not know when a downturn might come. You should consider taking at least a portion of your distribution if the market has been on a strong rally for a significant period. Likewise, if you are getting nervous about markets, take your distribution. Most importantly, hindsight is 20/20 so do not dwell on the past. Crystal balls do not exist.
- If you will be converting your RMD from U.S. dollars (USD) to Canadian Dollars (CAD), what is the exchange rate? If we see 1.45 again like we did last year, you should consider taking your distribution at that time because the currency conversion rate is much better than the average exchange rate of 1.26 over the past 25 years. The gain in currency conversion would need to be weighed with the value and trend of the overall portfolio.
- If you are taking distributions larger than your RMD to support your lifestyle, and you have assets on both sides of the border, pay attention to the exchange rate and take your additional distributions from the currency that is most advantageous. If the exchange rate goes to par (1 USD = 1 CAD), it would be a relatively bad time to convert from USD to CAD and we would recommend taking your extra distributions from your CAD accounts.
- Those who are adding to their portfolio should keep a smaller emergency fund (3-months’ worth of expenses) and invest additional savings as soon as possible because investment research shows that the number one factor to investment appreciation over time is how long you are invested. For those who are taking distributions for living expenses, keeping 6 to 12 months of expenses in cash can provide more flexibility for distribution timing. The worst case for RMDs is being forced to take the income during a market downturn at the end of the year, or during a trough because you need the cash for living expenses. The bounce back from the March 2020 low happened very quickly, and the correction next time may take much longer to recover. Just like a broken clock is right twice a day, future corrections will happen. We do not know when, how severe it will be, or how long it will take to recover. Try to take your distributions when the market has been up and keep enough cash to allow your portfolio to recover should we experience a correction.
- Maintaining a target equity allocation through rebalancing mitigates the effect of liquidating equities. If equities are down for the period, a higher proportion of the cash would come from fixed income securities. It’s still best not to liquidate during a trough. Some would argue that you just take your income from the fixed income side of the portfolio during a downturn. This is an option, but your portfolio risk exposure will grow too high if this strategy persists in a prolonged market retraction.
- While the taxation of Roth IRAs is not a factor upon distribution, the principles listed above are applicable any time you are taking distributions from an investment account.
- If you have an IRA, Roth IRA, and taxable brokerage account, you may want to consider balancing the distributions between the IRA and taxable account and save the Roth IRA for your heirs. Your taxable account creates taxable income for you annually, so it is better to spend that down rather than the Roth IRA. For Canadian residents, your taxable accounts are also deemed disposed of upon your death. Also, the Roth IRA is always tax free, during your life and after your death, and there are no RMDs.
- Lastly, if you have an IRA and a RRSP, you should consider taking additional distributions from the RRSP or RRIF rather than the IRA. Your RRIF minimum distributions are larger than IRA RMDs making it more advantageous to reduce the balance of your RRSP/RRIF earlier. Your RRSP/RRIF will also be deemed disposed of upon your death making it all taxable on your final tax return. Inherited IRA distributions can be taken over a 10-year period for individual beneficiaries, reducing the total tax payable and increasing your generational wealth transfer. If you are a Canadian resident and your beneficiaries are US residents, this means that your RRSP/RRIF will be fully taxable on your final tax return, but your IRA balance may be able to escape the more onerous Canadian tax regime completely.
The bottom line: being smart about distribution timing can make a big difference in the overall longevity of your portfolio, and in generational wealth transfer. You should not put your RMDs on an automatic distribution schedule and forget about it. There are several factors to consider when deciding when to take RMDs, and it is a more complex issue in a cross-border context. Cardinal Point specializes in cross-border Canada-U.S. wealth management and we can help you navigate all types of complex financial decisions. Contact your Private Wealth Manager to discuss your distribution strategy in more detail.