3678 / What strategies should a taxpayer consider when determining the level of distributions from retirement accounts during retirement?

The RMD rules ( Q 3682) require that taxpayers begin withdrawing funds from tax-deferred retirement accounts, such as IRAs and 401(k)s, when they reach age 73 (72 for 2020-2022, 70½ prior to 2020). The minimum amounts that must be withdrawn are calculated based on the taxpayer’s life expectancy, determined using IRS actuarial data.¹

The IRS provides tables specifying the percentage of current account assets that must be withdrawn each year based on the life expectancy of the taxpayer in any given year after reaching age 73 (72 for 2020-2022, 70½ prior to 2020; tables are also available for taxpayers beginning withdrawals at younger ages). In the case of a married couple where one spouse is more than
10 years younger than the other, the joint life expectancy of the couple is used in the calculation to provide a more realistic estimate of the combined life expectancy of the couple.²

The RMD requirements are generally not meant to provide retirees with guidance on the optimal withdrawal rate, but are meant to ensure that the funds in these tax-deferred accounts are used for retirement income, rather than as estate planning vehicles. Because the requirements seek to ensure that the assets are spent during life, they are a viable alternative to the so-called “4 percent rule,” even though this was not the original IRS intent in formulating the rules.

As the name suggests, under the 4 percent rule, the taxpayer withdraws 4 percent of the beginning balance of retirement savings each year during retirement. While the rule is very simple, it can have unintended consequences. For example, the rigid 4 percent-per-year requirement tends to encourage taxpayers to seek out dividend-heavy investments to supplement their otherwise fixed income, regardless of whether those investments are otherwise appropriate.

Further, the 4 percent rule has taxpayers withdraw 4 percent even in years when their assets may have severely underperformed. The converse is also true, as the rule limits taxpayers to 4 percent withdrawals even if they could afford much more.

Some advisors find that the RMD method should be considered as a potential alternative to the traditional 4 percent rule for determining retirement account withdrawal rates. Not only is the RMD approach almost as simple as the 4 percent rule—rather than withdrawing 4 percent each year, the taxpayer would consult the IRS tables to determine the applicable percentage—but it offers much more flexibility.

The RMD rule may be, in many ways, much more realistic than the 4 percent rule because it bases withdrawals on the current value of the taxpayer’s retirement assets. While this requires determining the account values each year, it also allows taxpayers to modify their consumption levels based on actual account performance. Because the percentages are based on life expectancy and vary with age, it is still unlikely that the taxpayer will outlive his assets.