Killing Me Softly with Jargon: RMDs

Another day, another acronym. The financial industry is rife with them, causing cringes, confusion, and avoidance, so I try to assume the mantle of translator from time to time. RMD is an important term to know, particularly if you’re approaching retirement, or if you’re already in the thick of it. RMD stands for Required Minimum Distribution, and it is the amount that the IRS requires you to withdraw from your tax-deferred retirement accounts when you turn 70 ½. Tax-deferred retirement accounts include qualified defined contribution plans (401(k)s, 403(b)s, 457s, and Thrift Savings Plans), as well as the basket of IRAs (Traditional, Rollover, SEP, and Simple). (There is one conspicuous exception in the lineup here – RMDs are not required for Roth IRAs since they are funded with after-tax money and therefore are not tax-deferred.) The catch here is that the RMD is tax-deferred money, so you will be liable for taxes on it at ordinary income rates.

There are two options for when you can take your first RMD. The first option is to take it anytime in the year that you turn 70 ½. The second option is to take it by April 1 of the year after you turn 70 ½. Initially, the second option seems like a boon, as it delays the administrative work and the tax hit into the following year. However, doing this can cause a much higher tax bill the following year, as you will also need to take your second RMD that same year. The result could even push you into a higher tax bracket, which should be avoided if possible.

A common question is, what happens if I have a motley crew of retirement accounts, do I have to take a separate RMD for each account? Well, you can combine all your IRA account balances and take one RMD from one of the IRAs, and combine all your 403(b) account balances and take one RMD from one of the 403(b)s, but if you have another kind of qualified defined contribution plan like a 401(k), you have to take the 401(k) RMD from that account only. So the answer is yes, aggregation is possible, but it depends on the account type.

If you’re still working at age 70 ½, your qualified defined contribution plan may allow you to defer taking your RMD until you actually retire, so it is worth checking with your plan administrator about this. It is generally prudent to continue realizing the benefits of tax-deferred compounding until you have to stop. If you’re still working at age 70 ½ and own more than 5% of the business, you can’t defer taking your RMD until retirement. Furthermore, your ownership can be attributed to your spouse and/or children also employed by that same business, and can prevent them from deferring their RMDs until retirement as well.

If for some reason (including but not limited to the cringes, confusion, and avoidance mentioned above) you missed the deadline to take an RMD, the IRA penalty is particularly harsh – 50% of the amount that you owe for the RMD. For example, if your RMD is $5,000, you would owe the IRS a hefty $2,500 (plus the tax you owe on the RMD itself). Of course, this money would be much better spent on… almost anything else.

How are RMDs calculated? Turns out it’s not an onerous process of sifting through IRS tables or identifying correct distribution factors, as the Internet is benevolent. I like Charles Schwab’s online RMD Calculator, which is simple and user-friendly. All you have to do is input your account balance as of 12/31 of the previous year, your date of birth, your primary beneficiary and their date of birth, and the rate of return you expect to receive on the account, and ta-da your RMD is calculated. The last thing to note here is that you are not limited to the RMD amount at any time – you can take out as much as you want, even the whole ball of wax. The piper – ahem the IRS – certainly won’t stop you as they are happy to collect the taxes whenever you are ready to pay them.

College Savings Plans: The Magic Number is 529

For a standout option for college savings, look no further than 529 plans. 529 plans are investment accounts with tax-deferred earnings and tax-free withdrawals, as long as they are used for qualified education expenses. 529 plans, also known as “qualified tuition plans,” are sponsored by states, available directly from plans or through advisors, and take their name from Section 529 of the Internal Revenue Code.

There is a second, little-known category of 529 plans called “prepaid tuition plans,” somewhat antiquated plans where you can lock in a tuition rate through the purchase of credits. However, these plans have many limitations and states are beginning to drop them. The first category of 529 plans discussed here have far greater visibility and popularity.

Along with tuition, 529 plans can be used to pay for qualified education expenses including room and board, fees, books, computers and related equipment, and supplies. However, earnings on withdrawals used for non-qualified expenses are subject to federal and state income taxes and a 10% federal penalty tax. 529 plans offer flexibility with choice of schools and can be used at a variety of institutions, including colleges, universities, trade or technical schools, and some foreign schools.

In addition to the benefit of tax-deferred earnings and tax-free withdrawals, some states offer tax deductions or credits for 529 plan contributions. In many cases, if the maximum deduction is met in one year, the deduction can roll over into subsequent years. Almost all states mirror federal law and offer state tax exemptions on withdrawals.

You don’t have to save in your state’s plan. The key is to first look at your state for tax deductions or credits, and if there is one, it usually makes the most sense to claim it. But if you live in a state with no income tax or you don’t have any tax deductions or credits available, by all means shop around with other states’ plans and compare and contrast their performance.

529 plans are very accessible, with investment minimums as low as $10 and high contribution limits. Individuals can apply the $14,000 annual gift tax exclusion to their contribution for one year ($28,000 for couples), or make up to 5 years worth of contributions at once by contributing $70,000, without triggering the gift tax ($140,000 for couples). For high-net-worth folks, this gifting strategy can be used to reduce the size of their taxable estate. Lifetime maximum account values are between $300,000-$400,000 per beneficiary, depending on the state, and a beneficiary can have multiple accounts as long as the total money in all accounts does not exceed the state limit on contributions. Anyone can contribute to 529 plans – grandparents, parents, aunts, uncles, friends, and so on.

The 529 account owner retains full control of the assets throughout the lifetime of the account, including the right to take the money back (although this would be a non-qualified withdrawal and subject to federal and state income taxes and the 10% federal penalty tax). If the original beneficiary gets a full scholarship, ends up with an unused balance, or doesn’t go to college, the account owner can change beneficiaries or transfer assets to another family member, as many times as needed. The IRS’s definition of family member is generous, including step-siblings and first cousins, for example. Account owners can also use the plan for their own educational needs.

To minimize impact on financial aid, it’s generally best for 529 account owners to be the custodial parent(s). Assets in a 529 plan held by a custodial parent count against need-based aid up to a maximum of 5.6%, whereas withdrawals from a 529 plan held by grandparents or non-custodial parents are considered untaxed income to the beneficiary the following year, and could reduce need-based aid by as much as 50%.

529 plans exclusively use mutual funds and offer two investment options. The first is an age-based portfolio option, similar to a target date retirement fund, where the investments shift from aggressive (high percentage of stocks) to conservative (high percentage of bonds and cash) as the beneficiary gets close to college age. The idea is that the portfolio increases the chance of gain early on and reduces the risk of loss later on. The second option is a static portfolio, where the funds stay the same over time, and the account owner rebalances as they see fit, up to once a year. Within both of these options you can still choose your risk tolerance and have a diversified portfolio. 529 plans are undeniably worth it – as JP Morgan Asset Management tracks it, even in its worst 18-year period, a 50/50 mix of stocks and bonds outperformed tuition inflation.

Lastly, a quick note about direct-sold versus advisor-sold plans. Advisor-sold plans have on average a 4.75% commission attached to them, increasing plan cost and cutting into plan returns. According to Morningstar, most 529 plan assets are invested in age-based portfolios, which are automatically rebalanced over time, and account owners tend to stick with this allocation. It makes you wonder, what is the need for an advisor then? In fact, Morningstar’s 2016 ranking of the best 529 plans overwhelmingly puts direct-sold plans at the top of the list.

Apples to Apples? Mutual Funds vs. ETFs

Let’s start with the basics. What is a mutual fund and how does it work?

A mutual fund is a pool of money received from investors that is managed by an investment company. Mutual funds issue and redeem shares at their net asset value (NAV), the price at which you can buy or sell a share that is calculated after the market closes for the day. So when you put an order in to buy or sell a mutual fund, it’s not executed until after the market is closed. This is why you can’t specify the price at which you’d like to buy a mutual fund, as the price is unknown until the market closes and the NAV is calculated. Instead, you have to specify the amount you want to invest in a mutual fund, for example $2500 worth of ABCDE mutual fund, and then the quantity of shares you end up with is determined by the NAV.

Moving on to ETFs – what is an ETF and how does it work?

ETF stands for exchange-traded fund (literally, traded on the stock exchange) and is a collection of assets that tracks an index. Examples are ETFs that track the S&P 500 or the Russell 2000, a sector like energy or biotech, a country or region like Vietnam or the Caribbean basin, a commodity like gold or coffee, or a currency, among others. ETFs offer more trading flexibility than mutual funds as they trade continuously when the market is open and can be sold short or bought on margin. As such, ETFs are traded at their current market price instead of their NAV, like stocks.

Tax

Investment returns of mutual funds are granted “pass-through status” under U.S. tax code, meaning that taxes are paid by the investor, not the mutual fund. When capital gains and dividends earned in the mutual fund are paid out to investors, typically once or twice a year, investors are liable for taxes on this income. This can lead to a few undesirable scenarios. One, the investor who just bought shares and receives a distribution is liable for taxes resulting from transactions that occurred before they bought the shares. This is a common concern late in the year when distributions are often made. Two, if the mutual fund loses value, particularly below the price at which it was originally bought, the investor is still liable for taxes on it. In general, owning mutual funds reduces the investor’s ability to manage their taxes.

By contrast, ETFs are much more tax-efficient as they are structured to shield investors from capital gains taxes. Redemptions of ETFs do not trigger a stock sale within the fund as they do in mutual funds, so no capital gains or any resulting taxes are passed on to investors. Of course, the investor is still liable for taxes with ETFs if they realize capital gains upon selling them or receive dividends.

Cost

Mutual funds are relatively expensive to own. Since they are actively managed by an investment company, the company incurs an array of fees that cuts into returns. These fees can be divided into two main categories. The first category is the operating expenses of the fund, which includes the cost of paying the fund managers, administrative fees, and sales and marketing fees (aka 12b-1 fees). These expenses are expressed as an expense ratio, which ranges from 0.2-2.0%, and the average mutual fund has an expense ratio of 1.25-1.5%. The second category is front- or back-end loads, which are sales commissions charged upon buying or selling the mutual fund. On the brighter side, there are no-load mutual funds available.

ETFs are significantly cheaper to own. Investors who buy ETFs do so through brokers, rather than buying directly from the fund. As a result, ETFs have lower sales and marketing fees, which translates into lower operating expenses that cut into returns. On the other hand, ETFs come with a trading cost. Unless they are a proprietary fund where the fee is waived, ETFs incur a brokerage commission.

Relatedly, the cost of buying in can be a deterrent for mutual funds. ETFs are more accessible to investors as they don’t have minimums, whereas mutual fund minimums can range from $5,000-$50,000.

Investment Strategy

Mutual funds are run by professional money managers who do the research to make the buying and selling decisions within the fund. The goal of this active management is to beat the market. For some investors, the allure of outperforming the market justifies the higher cost of owning the fund.

ETFs are overseen by professional money managers who try to match the ETF’s performance to its benchmark index and minimize capital gain distributions. The goal of this passive management is to track the market and not risk underperformance. For some investors, the perceived safety of a passive strategy is more desirable than the heightened uncertainty of an active strategy.

Pick Your Own

Overall, mutual funds offer an active management strategy designed to beat the market, at a relatively high cost, whereas ETFs offer a passive management strategy designed to track the market, at a relatively low cost. Mutual funds have more trading limitations than ETFs, but there are more mutual funds to choose from than ETFs. Many people want to know, which fund type is better? Not surprisingly, it depends on the investor’s financial situation.

For investors who manage their own portfolios, mutual funds could be preferable for those with a longer time horizon and little interest in trading, and ETFs could be preferable for those with a shorter time horizon and interest in more frequent trading. When considering taxes, ETFs could be better for investors who are sensitive to taxes. When considering performance, ETFs could be less compromised by fees, but mutual funds could have higher returns. And for investors who use investment managers to manage their portfolios, it is important to take a meta view with either fund type, as the success of the investment strategy is presumably the key determinant.