Let's take a closer look at the complications posed by RMDs, as well as the suitability of using dividend stocks to meet these requirements. We'll also examine some other RMD funding options that may appeal to investors.
Brief Overview of RMDs
In other words, contributions result in lower income taxes for many years while you save for retirement. However, ultimately the IRS does want to recoup those tax savings, which is where RMDs come in. We published an in-depth guide to RMDs here.
The way the formula works is that you take the value of all your applicable retirement accounts each year, and then divide that by the distribution period, which falls steadily with each passing year.
RMDs are taxed at your top marginal income tax rate which looks like this for 2019:
If your retirement accounts are large enough, your RMDs can eventually become substantial and thus result in surprisingly large tax bills due each April if you haven't planned for them correctly.
The Pros and Cons of Using Dividends to Fund RMDs
Note that for pass-through stocks, such as REITs and MLPs, the tax treatment is different. This article provides an in-depth guide to taxes for various kinds of income stocks.
In other words, investing in dividend stocks in tax-deferred accounts results in losing the lower tax rates dividends enjoy in taxable accounts. However, owning dividend stocks in retirement accounts provides several benefits, too.
For example, from 1930 through 2017 dividends accounted for about 42% of the S&P 500 Index's total return, according to Hartford Funds. From the mid-1920s through 2014, dividend-paying stocks with low, average, or high yields also generated annual total returns between 9.3% and 11.3%, ahead of the 8.6% return earned by non-payers.
Besides helping your retirement accounts grow over time, dividend stocks can also help you worry less during the market's inevitable downturns. While stock prices are unpredictable and often quite volatile over any short period of time, dividends have been much steadier.
The table below shows the S&P 500's peak decline and the change in dividends paid by S&P 500 companies for each recession and bear market since World War II.
Even if we include both the World War II recession and the financial crisis outliers, we can see from the table above that average dividend cuts during recessions represented a pullback of just 0.5%.
Simply put, U.S. companies try to avoid cutting dividends unless it's absolutely necessary. As a result, S&P 500 dividends tend to be much less volatile than stock prices, and our Dividend Safety Scores can help investors generate an even safer income stream.
Each year your retirement account custodian (companies such as Fidelity or BlackRock) will send you a 1099-R form. This is where you choose which accounts you'll be paying RMDs out of, and how you wish to fund them.
That might not sound like much, but if those early years coincide with a bear market, then the ability to avoid selling investments at much lower prices can improve your long-term retirement savings and provide more peace of mind.
And even later in life, when RMDs rise high enough that dividends alone can't cover them, you'll still be selling less income producing assets (which gain in value over time) and reducing your dependence on prevailing stock prices.
Therefore, dividends can serve as a reasonable way to not only fund initial RMDs but also help maximize your overall nest egg's size over the long term. However, in addition to dividends, there are other alternatives to RMDs that you can consider.
Other Alternatives to Funding RMDs
"In kind" withdrawals allow you to transfer an amount of securities equal to your RMD to a taxable account. This is an option because RMDs do not have to be taken in cash. However, you will still owe taxes on an "in kind" withdrawal, and the investments you transferred will now owe taxes on the profits (interest, dividends, and capital gains) they generate.
However, the benefit of an "in kind" transfer is that if you don't need the income to live off, you can meet your RMD requirement via this approach without having to sell shares, potentially at the bottom of a bear market.
The other issue to remember is that an "in kind" transfer will reset your cost basis on the assets you transfer.
For example, if you bought stocks for $10,000 years ago and they are worth $30,000 today, when you transfer them to cover your RMD you'll pay income taxes on that $20,000 gain since the entire $30,000 transfer value is taxable.
However, your cost basis will then reset to the $30,000 market value so any future tax liabilities will be based on gains above that amount. Don't forget this cost basis reset or you might end up overpaying your future tax bill.
Another benefit to lowering your adjusted gross income is that you may be able to avoid the Medicare High-Income Surcharge on Medicare Part B and D premiums. This applies to single and joint filers with adjusted gross incomes of $85,000 and $170,000 or above, respectively.
Closing Thoughts on Using Dividends to Fund RMDs
Fortunately there are ways to reduce some of the burdens and risks associated with RMDs, including the potential need to sell shares during a market downturn.
Ultimately, dividends, "in kind" transfers, and Qualified Charitable Distributions are solid RMD funding approaches that you should discuss with your certified financial planner when constructing or updating your long-term retirement plan.