Wanna Pay a 50% Penalty on Your Retirement Account?

There are some things to know about your retirement accounts that are incredibly important, not the least of which is that the IRS can force you to pay a penalty of 50% in addition to any taxes you owe if you screw up required minimum distributions (RMDs) from certain types of those retirement accounts.

(If this is way more than you want to know about IRA's, please skip ahead to the last two paragraphs. If you don't even have a retirement account other than a Roth IRA and don't expect to, maybe just check out 10 Supplies You Always Need at the Gym over at Buzzfeed.)

According to the IRS website,

"The RMD rules apply to all employer sponsored retirement plans, including profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs. The RMD rules also apply to Roth 401(k) accounts. However, the RMD rules do not apply to Roth IRAs while the owner is alive."

(So, you get a break from the IRS if you're dead. Good to know.)

A 50% penalty. Surely that got your attention.

There are basically two individual retirement account deals offered by the IRS: a traditional IRA and a Roth IRA.

The IRS offers a tax deduction when you contribute funds to a traditional IRA. You contribute "pre-tax" dollars. Because Congress didn't want wealthy people to be able to avoid taxation on those funds forever, they mandated required minimum distributions (RMDs). The effect of RMDs is that after age 70½, retirees must withdraw at least a certain percentage of their current traditional IRA balances and pay taxes on those withdrawals.

That's the bad news —  you'll have to pay taxes on your traditional IRA's when you withdraw and you will eventually have to make withdrawals. The worse news is that it will all be taxed as ordinary income, even if you earned the money with long-held stock investments. Preferred capital gains rates don't apply to holdings in an IRA.

Roth IRA's are the other, different deal. You don't get a tax deduction for contributions up front. You contribute after-tax dollars. The good news is that there are no taxable required distributions from individual Roth accounts (there are from Roth 401(k) accounts, though) and the contributions and any earnings on those contributions are never taxed.

Which is the better deal? That depends on whether your taxes are higher when you contribute or when you withdraw. And, that's fairly unpredictable.

The IRS enforces the RMD penalty if you don't withdraw the required minimum amount each year after age 70½. (The penalty may be waived if the account owner establishes that the shortfall in distributions was due to reasonable error and that reasonable steps are being taken to remedy the shortfall.) You will not only have to pay taxes on the correct amount of the withdrawal you didn't make on time, you will have to pay a 50% penalty on the shortfall and you will still have to withdraw the funds from your IRA.

This is a costly mistake you don't want to make.

The calculations look complicated (see Form 5329), but there are calculators on the web to help, and your investment company may even offer a service for free to remind you and calculate your RMD for you. Vanguard offers such a service, for example, though you have to be 69½ to enroll.

The minimum amount to withdraw is based on your life expectancy as calculated by one of three tables provided by the IRS. (Here's an easier-to-read version from Forbes magazine than IRS Publication 590 provides.)

If you are 72, for instance, the uniform table calculates your life expectancy as 25.6 years and that year you must withdraw the total of your IRA Account balances divided by 25.6. That's about 3.9%. At age 82, that will grow to 5.85% of whatever you have left in those accounts.

Recently, I received a couple of questions regarding RMD's and sustainable withdrawal rates. The common thread of the queries was, "What do I do when the IRS requires that I make withdrawals that are larger than my 4% safe withdrawal rate? Won't I deplete my portfolio too fast?"

(RMDs exceed 4%, for example, after age 73.)

The first thing to realize is that they're two very different things. SWR withdrawals are spent while RMDs are only taxed. The assumption is that if you didn't need the entire 4% SWR withdrawal in a given year, you would leave what you didn't spend in your portfolio.

IRA RMD's are withdrawn so that you a) must pay taxes on them and b) you stop any future tax deferrals on the withdrawal amount. The IRS doesn't say you have to spend the withdrawal. Just reinvest the balance after taxes into a taxable account. Heck, put it into the same mutual fund you took it out of, if you like, just do it in a taxable account.

The second thing to be aware of is that safe withdrawal rates also increase with time. According to William Bengen's original work, "SAFEMAX" is about 4.4% when you have 30 years left in retirement, 5.2% with 20 years remaining and 8.9% with 10 years remaining. Other studies show similar results (with the caveat that I don't trust any of them.)

Lastly, we can't assume that all of a retiree's portfolio resides in traditional IRA accounts. If half the portfolio is in taxable accounts, for instance, and half is in IRA's, a 3.9% RMD from the IRA's would only equate to a 1.95% portfolio withdrawal.

So, required minimum distributions shouldn't destroy your retirement spending plan unless it was developed with the incorrect assumption that you would never have to pay taxes on any of your retirement accounts.

To sum it all up, it is very important that you understand that there are certain amounts of your traditional IRA's and similar retirement accounts that must be withdrawn and taxed after age 70½. The rules are complex and violating them can cost you a bundle in penalties.

If tax gibberish is just beyond your attention span (in other words, you are normal), then I suggest the following. Make a note to call your tax professional or your mutual fund customer service department on your 70th birthday and ask what you need to do about required minimum distributions or "RMDs". Or call that customer service department today and ask if they offer a reminder service.

A potential 50% penalty should be plenty of incentive.

A New Ponzi Scheme Every Week

I interrupt this blog stream for a public service announcement. One of the biggest risks to your retirement finances is fraud. Some call it “elder fraud”, but the fact is that Bernie Madoff destroyed the futures of a lot of people who were by no means elderly.

I was reminded of this topic by a New York Times column this morning written by Elizabeth Olson and entitled, "Despite Exposure of Madoff Fraud, New Ponzi Schemes Emerge" that noted that a new Ponzi scheme is uncovered nearly every week.

Ponzi schemes aren’t new. Charles Ponzi created his in the 1920’s, but Charles Dickens wrote about such a scheme in his novel, Martin Chuzzlewit, in 1844.

In, How to Smell a Rat, Ken Fisher does an excellent job of describing how to protect yourself (and your retirement) from fraud. I recommend the book. It’s a quick read that could save your savings.

I think the two most important points in Ken’s book are to expect reasonable returns on your investments and not to give your money away.

A gentleman called me not long ago to discuss retirement planning. He argued that he was currently investing in a financial product with a “safe” return of 9%. I could not convince him that the investment was risky. His arguments sounded like they came straight from a very good salesman.

I knew nothing about the investment, so why did I find it so suspicious? Safe investments today return about a percent or so. Any investment that needs to pay you 9% is not safe. Thinking you can earn a high rate of return with little risk gets you into trouble every time.

But, do people really freely give their money away to fraudsters? All the time.

Fisher recommends you never give your money to your financial planner. You can trust your money to a safe third-party like Smith Barney, Fidelity, Schwab or Vanguard and enter into an agreement whereby your financial adviser can trade in your account but cannot withdraw your money.

I used Ken Fisher's company to manage my portfolio for a while. They never asked for custody of my funds. Instead, they offered two companies for me to choose from and we went with Smith Barney. I opened a brokerage account at SB, deposited my funds there and entered into a contract for Ken to provide investment instructions to my broker. Ken instructed SB on what to buy and sell within my account but his company never had control of my money.

A scam artist can send you investment reports that look real while stealing your money. A trusted third-party will send you reports that you can trust and will be responsible for your money.

You have to be very careful with this one. Madoff clients thought they were leaving their money with a trusted third-party, but it turned out that Madoff controlled that company, too.

I said two key points, but here’s a third. Never let an investment salesman convince you that you’re getting in on an investment opportunity that most people don’t have access to. The suggestion that you are somehow being admitted to an exclusive club is a red flag.

You can go a long way toward protecting your life savings with those three rules. Never believe that you can make lots of money while taking little risk. Never give custody of your funds to anyone except a trusted, well-known financial firm. And don’t let anyone convince you that you’re getting in on something special and exclusive.

If you have any doubts, don't invest until you're confident. 

You worked hard for your money. Don’t give it away.

Half Right

One way to look at retirement planning is with a spreadsheet. We make some assumptions, like 5% portfolio returns and 3% inflation and we build 30 rows representing as many years, with the same average assumptions plugged into each row.

The world doesn't actually unfold that neatly, of course. We get returns that can vary widely each year, and if you're buying and selling along the way, it isn't nearly the same thing. This variance of returns introduces sequence of returns risk when we are accumulating or spending from a volatile portfolio and the spreadsheet doesn't capture that.

Market crashes can cause wealth-destroying panic selling and high portfolio variance can increase longevity risk. The typical spreadsheet analysis doesn't account for any of that.

Most importantly, half the time your return will be more than the average and half the time it will be less, so if you assume an average return of 5%, for example, and need at least 5%, you will fail half the time. (Technically, that's the median and not the average, but I'm assuming they're pretty close in this situation.)

This chart shows a probability density function of portfolio returns with a mean of 5% and standard deviation of 11%. Your actual returns can fall anywhere along the x-axis, but most will fall somewhere close to the average return of 5% in the middle.

Your actual return could fall to the right of the average and exceed 5%, or to the left and be less than 5%. The dotted line shows the average, which tries to represent all of that data in a single number in a spreadsheet. But there's a 50/50 chance that your return will be less than 5%. A 50% chance of being wrong is more risk than a conservative retiree might want to take.

To address these problems, many planners and nearly all academics prefer to use Monte Carlo simulation, instead. Monte Carlo generates many outcomes and, unlike the spreadsheet approach, shows the distribution of outcomes, like this graph, and the probabilities of each occurring. It also simulates sequence of returns risk and creates some "market crash" scenarios.

Instead of simply using an average that we will under-perform half the time, Monte Carlo can also tell us what rates we are likely to outperform 80% or 90% of the time, for example.

Is there a way to use a spreadsheet and incorporate this volatility risk that would typically remain hidden? Wade Pfau recently published a column in Advisor Perspectives entitled "New Research on How to Choose Portfolio Return Assumptions" attempting to answer that question. I won't repeat his findings in detail — I hope you will read his analysis — but I will summarize the results.

In simplest terms, Wade performed a Monte Carlo analysis to generate a random variable with a median return of 5% (the same as the spreadsheet answer that is exceeded 50% of the time) and standard deviation of 11% and then calculated what the returns would be with more conservative assumptions, like the return that would be exceeded 90% of the time, also known as the 10^th percentile.

Wade confirmed some guidelines suggested by financial planner, Daniel Flanscha, who noted that when he uses a fixed return assumption (a spreadsheet analysis), he subtracts 1.0% to 2.5% from the return during the accumulation phase and 2.5% to 4.0% from the return during the distribution phase to account for the effects of randomness.

Wade found that compared to performing Monte Carlo simulation of a retirement spending scenario with a median geometric return of 5% (arithmetic mean of 5.6%) and volatility of 11%, a return you could expect to meet or exceed 50% of the time, you could provide a reasonably conservative result, one that might be met or exceeded in 90% of cases, with a spreadsheet by using an expected return of 1.9%.

Here's our portfolio returns probability density function chart with the dotted line now showing the more conservative 10^th-percentile figure of 1.9%.

There are several important take-aways from this analysis, the most important of which is that volatility costs a lot. Subtracting 1.0% to 2.5% from your return assumption during the accumulation phase and 2.5% to 4.0% from the return assumption during the retirement phase of planning eats a lot of your expected portfolio return.

Second, it shows that sequence of returns risk is greater during the spending phase than during the accumulation phase. In Wade's example scenario, you would subtract 2% during the accumulation phase, but 3.7% during the retirement spending phase. I think I showed that with my discussion of sequence of returns risk, too.

Lastly, as an anonymous commenter to the column noted, conservative stock returns start to look a lot like bond returns:

"Given the 1.9-2.5% real projected returns at the 10^th percentile that you use for the example, by the time you subtract any management fees, transaction costs, and/or fund expenses, the real returns would be in the range that's quite attainable with a carefully laddered long bond-only income portfolio where the bonds are held to maturity. Even if the 50/50 portfolio at the 10^th percentile might do slightly better than the bond ladder, the difference in real return might not be worth the risk. . ."

To which Wade added:

"this is an important point about how a conservative rate of return assumption starts getting close to the internal rate of return from a bond ladder. There is one important difference, however: the bond ladder will not have upside potential, while the diversified portfolio could perform better. Remember, this is a conservative return assumption."

The diversified portfolio could also perform worse; there's a 10% chance of that happening. In fact, Wade's analysis assumes that the individual earns market returns, which is a big assumption. Most don't. Underperform those stock market index returns with your own investments and you do have bond returns.

Still, there is a much better chance that you will do better than worse at the 10^th percentile.

Be careful with tools other than your own spreadsheets, as well. E$Planner, for instance, used to use spreadsheet-like calculations until it began to incorporate a Monte Carlo function. Monte Carlo is still optional. (You can implement Monte Carlo simulation in a spreadsheet, just know whether or not you are.)

It was spreadsheet-like thinking that led Peter Lynch to infamously suggest that 7% should be a sustainable withdrawal rate and many people to think you can always make a profit earning an average market return that is higher than your mortgage cost.

It's half right.

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