End of Year Rebalancing and a Required Minimum Distribution

In January of this year, I wrote one of my favorite posts after helping a retired couple free themselves from their financial advisor, greatly simplify their portfolio, and saving them more than $20,000 per year in the process.

For details, please read From 28 Funds to 3, then return here for a follow-up. In summary, the couple previously owned 28 funds (with 48 positions between three accounts). The weighted average expense ratio was 0.64 and they were subject to an AUM fee of 0.73%.

By the time we were done, there was no AUM fee, the portfolio’s expense ratio was 0.08%, and their desired asset allocation of 45% US Stock, 15% International Stock, and 40% Bonds was maintained. The move saved them over $20,000 per year in fees.

To avoid paying capital gains taxes, we hung on to a couple mutual funds in the taxable account, but the vast majority of the portfolio was converted to a simple three fund portfolio.

 

The First Required Minimum Distribution (RMD)

 

The husband and wife each hold an IRA, and they both turned 71 this fall. That means they both turned 70.5 this spring, and the time has come for each of them to take their first RMD. As I did with the extreme portfolio makeover, I offered to help them with this process.

The IRS allows you to take the very first RMD as late as April 1 of the year after you turn 70.5, but after that, each one must be taken by the end of the calendar year. In order to avoid having to pay taxes on two sets of RMDs in the same tax year, we decided to take the first distribution in December of 2017.

 

What is a Required Minimum Distribution?

 

The IRS doesn’t want people to avoid paying taxes on tax-deferred accounts forever, so you’re required to withdraw a specified amount annually once you’re past your seventieth birthday. If you fail to do so, you’ll pay a stiff penalty equal to half of the RMD, or about 1.8% to 26% of the retirement account, depending on age.

The percentage of the portfolio required to be liquidated (and subject to income tax) starts at 3.65% at age 70.5 and slowly ramps up until it finally plateaus at 52.63% at age 115.

At age 80, it’s 5.35%. At 85, 6.76%. Age 90, 8.77%. By age 100, it’s over 15% and exceeds 25% at age 107. I don’t know if living that long would be considered lucky or unlucky, but this system will probably be long gone 65 years from now, so I’m not going to worry too much about it.

There are a couple exceptions to the “required” part of the RMD.

If you are still employed, you are not required to take the RMD from your current employer’s 401(k), although any IRA or old 401(k) with money remaining will still be subject to RMD. You also have the option of donating to charity directly from your account in lieu of withdrawing the RMD. You can do so tax-free for an RMD of up to $100,000.

Under the current tax code, Roth accounts are not subject to RMDs. For more information on RMDs, see what our friends at the IRS say in this RMD FAQ.

Therefore, another way to avoid ever being forced to take an RMD is to completely vacate your tax-deferred accounts via withdrawals and Roth conversions prior to age 70.5. Whether or not it makes any sense to do so will depend on the size of your tax-deferred accounts, the age at which you retire, and the tax bracket you find yourself in as a retiree. Personally, I don’t plan on having any tax-deferred dollars left by the time I reach 70.5.

 

Withdrawing the RMDs

 

The portfolio we’re working with is held at Fidelity, and the brokerage makes it very simple to click through and take your first RMD. When logging in, this is the first thing we see, front and center.

 

Fidelity RMD

 

Fidelity tells us how much to withdraw, and the couple had spoken with their accountant and knew about how much money to withhold to pay federal and state income taxes based on both the total value of the two RMDs plus additional income sources.

We opted to round up to the nearest hundred dollars on the RMD and similarly made sure we withheld at least as much as recommended by the CPA for federal and state income taxes. It was straightforward to accomplish on Fidelity’s website, and we repeated the process for both husband and wife. Altogether, both RMD’s were withdrawn and taxes withheld in under ten minutes.

 

Rebalancing the Portfolio

 

We had initially talked about rebalancing once or twice a year, but a peek at the portfolio over the summer showed we weren’t too terribly far off the desired 60/ 40 Stock / Bond ratio, so we let it ride.

Now that we had taken the RMDs, dumped the dollars into their taxable account’s money market fund, and transferred some excess cash from a checking account,, we had some cash to deploy and some work to do to get back to the desired asset allocation.

Before I discuss what we did here, I should mention my own rebalancing strategy. It can be summarized in three words.

I wing it.

When accumulating, it’s pretty easy to just keep track of the current state of affairs and every month when it’s time to make an investment in my taxable account, I put money into whichever category has a deficit. If things were to get really out of whack, I could exchange in my Roth or tax-deferred accounts, but that doesn’t happen too often.

How often should one rebalance? If you’re not rebalancing “on the fly” as I do, you ought to rebalance on a set schedule Once or twice a year should be sufficient, and you might also set limits on how far out of balance you’ll allow the portfolio to drift. For example, rebalance when an asset class is off by at least 2.5% or 5% from desired (62.5% or 65% stocks when you want 60%).

For additional information on rebalancing, please see The White Coat Investor’s excellent overview.

 

seesaw balance

a little out of balance

 

Rebalancing with a Spreadsheet

 

In the “decumulation” or withdrawal phase, winging it doesn’t work as well, since you’re not adding money on a regular basis anymore. If you’re in a situation where you’re making frequent withdrawals on a regular basis, you could simply take from the asset class that is overweight, but that’s not the approach this couple is taking. I suspect they’ll be withdrawing from the portfolio once per annum at the end of the year.

This is what the couple’s portfolio looked like after the RMDs and before any rebalancing. Note that His and Hers refer to the two IRAs and the Joint account is a taxable brokerage account.

 

 

This isn’t too bad. You can see we’re a little heavy on US stock and light on bonds; that’s not a big surprise given the year we’ve seen with US stocks up about 19% year-to-date. International stocks are a touch overweight, as well. The cash holding is unnecessary since the couple holds a substantial emergency fund with more than six month’s expenses in a separate account not tracked here.

How do we go about rebalancing? With more spreadsheet work!

First, let’s define the goals. I set out to accomplish two tasks in the most tax-efficient manner, and we were able to achieve both in four moves.

The first goal was to get back to the original asset allocation of:
• 45% US Stock
• 15% International Stock
• 40% US Bonds

The second goal was to move the international allocation from the tax-deferred IRA to the taxable account in order to take full advantage of the international tax credit, which would be wasted in a tax-advantaged account.

To avoid any potential capital gains taxes, we planned to avoid selling mutual funds in the joint taxable account.

This is what the asset allocation looked like prior to rebalancing.

 

RMD allocation

 

To get back to where we wanted to be, I multiplied the percentage by which we were off by the total value of the entire portfolio. I then made one move at a time to get us to the desired allocation. The two goals were met with a total of four tax-free transactions.

 

Rebalance Moves

 

Moves Reblance

 

When the transactions are complete, we’ll be right back where we want to be. Rebalancing maintains the desired asset allocation, keeping the risk level at the appropriate level selected by the investor. Some evidence suggests improved returns with regular rebalancing, but that isn’t necessarily the case in every situation.

In order to rebalance your own portfolio, you can set up a spreadsheet similar to the one you see here. The only formulas we used are simple addition, subtraction, multiplication, and division. I had essentially no experience with spreadsheets before I started using Excel in recent years, and it’s not difficult to learn. The ability to work a spreadsheet is an exceptionally useful skill for the DIY investor.

 


Track your investments for free with Personal Capital. That's how I track the PoF portfolio.  

 

Have you had any experience with RMDs? Do you rebalance with a spreadsheet? What’s your rebalancing strategy? Let us know if the comment box below!

 

Find FIRE with me.

Get an amazing spreadsheet, new post notices, & a quarterly newsletter.

We won't send you spam. Unsubscribe at any time. Powered by ConvertKit

32 comments

  • I’m a long way from RMD’s and like you don’t plan on having much in my tax-sheltered accounts by the time I get there.

    As for rebalancing, I do use a spreadsheet but I’m not super-disciplined about staying exactly on target numbers. Mainly because my thoughts on what my stock/bond ratio should be changes a lot. Also, I have a TSP account with a target date fund and that makes rebalancing a pain as I have to split that money up by the fund’s allocation, which is changing all the time.

    Nice job helping that couple out!

    • I can’t imagine I’ll have much in tax-deferred when the time comes. I plan to liquidate the 457(b) in my forties, and the 401(k) is only about 12% of my portfolio.

      If we have a 24% tax bracket that stretches all the way to $315,000 for married couples as proposed, I may be tempted to convert the entire 401(k) money to Roth in just a few years.

      The spreadsheet can make rebalancing with the target date fund a breeze. You would just have to update the percentages when the fund changes its allocation.

      And you really shouldn’t vary much on the stock / bond ratio. Make up your mind! I think You Need an IPS.

      Cheers!
      -PoF

      • Toby

        Agreed – My spreadsheet makes dealing with a Target Date funds simple. Just match the %’s as they change over the years and you’re good to go.

  • Subscribe to get more great content like this, an awesome spreadsheet, and more!
  • I don’t use spreadsheets for rebalancing, as my investments are pretty simple for me to estimate the changes I’d need to make. For people in the accumulation phase, one key thing is to avoid selling shares in taxable accounts for the purposes of rebalancing — either use retirement accounts or new money deposited into accounts for rebalancing.

    • Excellent points.

      Even when we untangled the messy 28 fund portfolio, we sold enough losers to offset the winners, resulting in no significant taxable event.

      If you find yourself in the 15% tax bracket (or 12% in the future?) — whatever the 0% capital gains bracket will be — then you may have some ability to make changes in taxable without owing taxes, but there’s usually an easier way to do it in the tax-advantaged accounts.

      Cheers!
      -PoF

  • This is incredibly useful. My parents will need to do this very soon and I have been trying to read up on RMD’s as much as possible. Great overview!!!

  • Toby

    Rebalancing a static value isn’t too bad, but my spreadsheet skills start to falter when rebalancing with new contributions (Backdoor Roth). When I add new money, it throws the new total percentages off. It can be done, but I haven’t found an elagant spreadsheet way of doing it yet.

    • I’m not too nitpicky with my portfolio. I just throw money at whichever category is underweight. I’ve had to increase the bond portion of my 401(k) a few times to keep my bond allocation around 10%. Easy enough to do.

      Cheers!
      PoF

  • hatton1

    I usually get a December surprise from a couple of mutual funds and I use that money to rebalance. Keep up the good work.

    • It’s dividend time in a few days — I’ll have to keep an eye on Vanguard right before or after Christmas. I’ve stopped the auto-reinvestments as they can mess with Tax Loss Harvesting. Not that there have been any real opportunities to do any this year.

      Cheers!
      -PoF

  • Thanks for sharing this, POF. It is helpful to see real-world examples and how they have an impact on a person’s retirement funds. You’ve also helped me a great deal with choosing the best options for a tax-efficient taxable account! Cheers – GE

  • Question for you POF, I know of Roth conversion ladders in early retirement, but will your account truly be small enough (or your taxable income be low enough) in early retirement and/or will you really have enough time to convert the entire pre-tax account to Roth by 70.5 ? Or are you simply planning to either have converted it by that point or used the account funds? Just curious what your plan of action is?

    RMD’s are one of the reasons that I invest via Roth in my 403B despite common advice to do the opposite. In addition, I can avoid the massive RMD’s my heirs would have to pay when I give things over to them. I also don’t know what the tax code is going to look like in 30 or 40 years.

    Great post to get everyone thinking about this important topic!

  • I rebalance twice a year, January and July. Though it has become more complicated as my number of accounts has grown (ah first world problems…). Still it is fun to do and notice the growth in those accounts. Thanks for laying out a tutorial…nicely written my friend!

  • A lot of moving parts–RMDs, rebalancing, taxable and tax-advantaged accounts, and three asset classes. I don’t see how you manage it all without a spreadsheet. I’m years away from RMDs, but I still use a spreadsheet nonetheless to maintain my asset allocation. And as of today, I need to move $26K in stocks over to bonds/cash. I’ll make that trade in January. Thanks for the great tutorial on RMDs and rebalancing, PoF. I learned something today!

    • Always happy to help.

      Some basic spreadsheet skills are just about mandatory for a DIY investor. Fortunately, it’s not difficult to learn, but those who use them in their jobs certainly have a leg up on a lackey like me who had no prior experience.

      Cheers!
      -PoF

  • Hatton1

    I think one advantage to having most money at one location (vanguard) is it is easy to use their portfolio tools to figure out how to change your allocation

    • That sounds pretty slick. I don’t know too many investors with all their money in one place like that, though. My 401(k) and 457(b) hold Vanguard funds, but they’re held at Transamerica. And my individual 401(k) is with eTrade.

      Best,
      -PoF

  • With a 401(k) there is an exception to RMDs. If the plan has provisions for delaying RMDS, the person continues to work and own less than 5% of the company then RMDs can be deferred so long as employment continues. Unfortunately, this probably excludes solo 401(k)s.

    For a person providing services with no tangible assets in their company it would seem arguable that the owner owns 5% of nothing which meets the 5% criteria. I doubt the IRS sees it this way. Anyone familiar with a special rule for deferred solo 401(k) RMDs?

  • Pingback: Roundup 8 - Ideal REI

  • Great article. I love your “Required” AND “Mandatory”, which is funny. Except it’s actually called the Required Minimum Distribution by the IRS (I found using your link!).

    My husband and I retired “late” for the FI community, at 51 and 56 and we are currently keeping our income low enough for Obamacare subsidies. Since we have 2 rentals for income, there isn’t much room for the Roth Conversions and we’ve got a boatload of our net worth in IRAs. I can’t figure it out. Possibly we will consider doing one of the health care ministries and let our income go over the 4 times poverty limit. That’s all I can come up with to avoid it.

    Also, note that once you are 73, you step over the 4% rule, so people should be ready for that. There is an annuity you can choose to lower your RMD by 25% called a QLAC. It basically is an annuity that you get nothing until age 85, but it helps with the safe withdrawal rates and risk of out-living your money.

  • Thanks for all of the good info here, it’ll come in handy when I’m in the decumulation phase… which will be many years from now. During the accumulation phase, rebalancing is easy (nonexistent) since it’s 100% VTSAX (plus Blackrock Russell 1000 index since there’s no vanguard in my 401k)!

    How long has the RMD system been in place? Do you really think the system and RMD percentages will be much different in 65 years or so?

    • A one-fund (or one asset class) doesn’t require any rebalancing at all, does it? But it you wanted to add a second class like international stocks, you’d want to pay a little attention.

      As far as I can tell, RMDs have been around since the TEFRA act of 1982, so at least 35 years. 401(k) started a few years earlier in 1978. I won’t pretend to know what life looks like in 2082. If I’m still around, I’ll probably be half cyborg. I will have blown all my tax-deferred savings on titanium body parts.

      Cheers!
      -PoF

  • RMD’s = Scary.

    I’m hoping to “top off” my tax brackets with Before-Tax 401(k) conversions to ROTH, starting at age 55. I likely won’t be able to convert big $$ in any given year, but I’m hoping that doing it consistently for 15 years will put a big dent in those RMD’s. Because, you know, they’re scary.

    • With the new 24% tax bracket stretching all the way to $315,00 (MFJ), if I were in your shoes, I’d be tempted to convert generously in the coming years. I suppose it depends on what other income you’ll have and how many years you want to spread it out, but that’s not a terrible bracket in which to make conversions.

      Best,
      -PoF

      • GREAT Point, Doc. I was thinking in terms of the old tax structure and hadn’t revisited my thinking with the new tax brackets. You’re on to something!! I started a post tonight about what I’m calling “A Loophole which benefits early retirees”. Credit to you for highlighting the issue. I will, of course, backlink to your post! Trust you’re cool with that?

  • Gasem

    I wrote a spreadsheet to determine whats the best amount to Roth convert, to the top of the .12 bracket or .22 bracket. I looked at the .24 bracket but I’ll be long dead before the extra taxes of that bracket break even. The problem is I have a 1.4M tIRA which I want to reduce in value prior to RMD, I have cash to live on till RMD hence no taxes and I have 4 years till RMD, so I can pull money out to the top of the bracket, 101400 for .12 or 165000 for .22. or 405,000 at ,12 or 660,000. Tax bit on 405000 is 35628 but tax bite on 660,000 is 91596 or a 55968 difference. At 6% growth my 1.4M becomes 1.32 M if I take out 101400, but it becomes 1,043,906 if I take out 660,000

    1043906 is MUCH more desirable since the RMD is much smaller so I have far better control of the tax bite BUT I have to pay a lot more taxes upfront. You either pay more taxes up front or you pay more cumulative taxes as time goes on on the larger tIRA In addition the larger Roth amount compounds more quickly. After doing a lot of calculations I determined it takes 14 years to break even from a tax point of view but I wind up $350K ahead in the Roth account

    my calculators are

    http://taxplancalculator.com/calc

    http://www.calculator.net/future-value-calculator.html

    https://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/ira_calculators/rmd

    RMD is nothing to fear but you have to plan in plenty of time to make a difference

    At .24 tax level my total tax bite would be 233000. My tIRA would be pretty much empty (155K left) but it would take forever to make up that tax bite.

    Facility with spreadsheets = power

    My conclusion is to take out 165K for 4 years then take out enough to pay for RMD plus 25K You cant put RMD into a Roth but you can dollar cost average money above the RMD into the Roth.

  • Pingback: The New Tax Law Loophole That Benefits Retirees - The Retirement Manifesto

  • Pingback: 20 Steps to Effective DIY (Do It Yourself) Investing | Passive Income M.D.

Leave a Reply

Your email address will not be published. Required fields are marked *