Money Talk

Episode 24

The Required Minimum Distribution. Suspension and Investing in Volatile Time.

Today’s topic will deal with two distinct areas. One, the suspension of the required minimum distribution occasioned by some legislative changes in the CARES Act. C-A-R-E-S Act. Also, investing in volatile times such as today.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Ed: I’m Ed and with me today is Chuck. Chuck?

Chuck: Hello and welcome.

Ed: Today’s topic will deal with two distinct areas. One, the suspension of the required minimum distribution occasioned by some legislative changes in the CARES Act. C-A-R-E-S Act. Also, investing in volatile times such as today. Let’s first focus on the question of the CARES Act and the suspension of the required minimum distributions. Specifically, the act doesn’t require you to make up the suspended portion of your otherwise applicable required minimum distribution. Anyone who has an RMD due in 2020 for example, a company plan year, 401(k) plan, 403(b) or your IRA qualifies including beneficiaries and including those who turn age 70 1/2 in 2019 and had to take the first RMD by April 1 of 2020. Now, there are a fair number of benefits. This is occasioned because December 31, 2019, when the DOW was about 28,500 compared to where it is today and continuing to decline. The required minimum distribution is based on the 12/31/19 value. You apply that percentage given the table expressing regulations. That’s the amount of your required minimum distribution. Is there a downside? Well, I’m not sure. Chuck, do you know the downside of not taking your required minimum distribution?

Chuck: Well, I guess there’s a couple of things. First of all, some people obviously just don’t have a choice. They need that in order to live off of. For them, this was a purely academic discussion. I guess the other thing is that for some people, there’s a tax play here which is that if you continue to take a distribution each year, you can do that and perhaps that distribution will not be a sufficient amount of money when added to your other income to push you into the highest income tax bracket versus if you think about who might be inheriting your IRA after you pass away. That might be somebody who’s in a higher income tax bracket than you. So there’s an advantage in those situations for someone to continue to take distributions at the lower brackets during their lifetime versus leaving the assets to be taxed at a higher bracket later. I’ve heard some discussion about people who are essentially thinking about this in terms of that same tax arbitrage standpoint but based on a prediction that tax rates will be higher in the future for everybody than they are today. I don’t know what you think about that, Ed. I always am cautious about trying to engage in things based on what you think is going to change about tax legislation in the future because it’s like trying to time markets or pick individual stocks. That’s a game that you can play and you can be right but you can also be wrong as often or maybe more often than you’re right. I think we all learned a lesson about that in 2010. I know I did.

Ed: Well, the other side of that, a principle is you never prepay a tax. I’m not sure that’s relevant.

Chuck: Exactly, yes.

Ed: That happens to be my fascination. My hobbyhorse. The first self-gratification deferred tax. Why? Because no one ever knows. Now, we do now in this era with what’s going on in the country, tax rates at least in the near term are going to be higher. How do you finance all these government expenditures? One approach is, remember, this eliminates the RMD for this year, a Roth IRA, that is, you can Roth a distribution from your existing tax-qualified arrangement because that doesn’t relate to a required minimum distribution, or expressing in another way, you cannot convert into a Roth your required minimum distribution. If there is no required minimum distribution, A, and B, you think rates are going to increase in the future, then C, you consider Roth at least the amount of your otherwise required minimum distribution. Moreover, along these lines in terms of a vehicle for the element distribution of your assets via an IRA, think about multiple IRAs. Maybe one you’ll Roth entirely number one, number two, you will not and maybe you’ll have IRAs equal to the number of your children. If you have five children, you would have five IRAs, and assuming you take the same amounts out of each IRA, you have then an arrangement that will pass directly to their child or via disclaimer to that child’s children which is a marvelous planning device avoiding probate and yet pushing the asset down into multiple generations. The problem with the Roth is once it’s converted, it can’t be undone. Moreover, the charitable distributions, we call those the QCDs, where you can have a distribution of up to $100,000 from your IRA directly to one or more qualified charities, but you must be age 70 1/2 to qualify. Even though there’s a change on the date for the required minimum distributions having been increased 70 1/2 to 72, the QCD still applies to age 70 1/2. So part of your planning is having that charitable distribution which in effect doesn’t take it into income or using a Roth conversion and the assumption that as we, I think it’s valid in this economic context, rates are going to increase in the future. Moreover, you must think about the element identity, the beneficiary of your IRA. If it’s to a non-spouse, Chuck, we have an issue there, don’t we?

Chuck: Yes, we do. That’s the other thing that occurred with the enactment of the SECURE Act in this last December was that’s what changed the required beginning date from age 70 1/2 to age 72. The other thing it did is that for inherited IRAs and there’s certain exceptions, the largest one being a surviving spouse, but for most inherited IRAs that are going to be received by anyone other than a surviving spouse, the entire IRA balance must be distributed within 10 years of the IRA owner’s death. Now you no longer have to take that beginning with year one after the IRA owner’s death, but by year 10, it needs to be exhausted. So for these larger IRAs, that can create a big tax bottleneck in the sense of having to accelerate that taxable income which then again, same rule will apply to the Roth but in the case of the Roth you’re talking about that person who inherits it is not going to be taxed on the income. I’ll parrot your comment there, that this is a good year for people who take the amount that would otherwise have been the required minimum distribution or even more than that and do a Roth conversion, keeping in mind you do pay income tax. That’s taxed as a distribution when you make the Roth conversion. So you need to have money from some other source to pay the income tax on the amount that you’re converting to a Roth. Everybody has to do their own math on being able to do that, but if you can figure out how to pay the tax on the conversion, it’s a great year to do that because you don’t have to do both the conversion plus your normal required minimum distribution.

Ed: Having said that, we know that there are eight or nine states where there is no income tax at all. I’m talking about state tax, not federal tax. We have 14 states which states do not tax distributions from tax-qualified arrangements. Again, how does this relate to you and what is your income bracket, state and federal if there is a state tax and you have to do the math. I think most importantly, this 10-year distribution role now there’s going to take out 10% a year, although there is an exception to the premature distribution tax penalty that provides for an annuitized pro-rata distribution, which we’re not talking about. We are talking about the 10-year distribution rule that is under the new act with a 10-year drop-dead date. You can take everything out in year one or spread it out over the 10 years, but it must be emptied at the end of the 10th year. Having said that, a normal situation with a reasonable amount in an IRA, you can eliminate this issue of the 10-year rule by providing that let’s assume we have a significant IRA in the hands of a surviving spouse and that can go– We’ve got a long distribution period there measured by the surviving spouse’s life expectancy. Well, the balance remaining at the death of the surviving spouse could be sent to a charitable remainder trust for the benefit of a child or children, which then means the distributions will be spread out, no tax paid at the death of the surviving spouse. No tax paid when the IRA is sent to the charitable remainder trust but a tax paid when the distributions are made now over the life expectancy of the beneficiary of the charitable remainder trust with the balance going to one or more charities selected by the individual who set up the CRT. Putting it in another way, for every legislative enactment more likely than not, there is an option to avoid the application of that Act. Is that your view, Chuck or am I a little crazy here?

Chuck: No. I think that that’s exactly right. I would put maybe a little ‘after death’ to your comment because I would say there’s always a way of avoiding the application or the intent of that enactment but generally, there’s always some kind of price you have to pay in order to avoid that and in a case of the charitable remainder trust as a beneficiary of an IRA, I think you and I are both humungous fans of that strategy the catch, of course, being that on the death of the person who is the beneficiary of that charitable remainder trust, you don’t get to pass that IRA on to yet a third person. That’s the price you pay in order to essentially be able to stretch that IRA. I think you and I are both on the same page that that’s a pretty small price to pay, given the benefits and given the fact that most people who are in a position where they need to worry about stretching an IRA past that 10-year payout period are in a position where they can afford to be charitable as well.

Ed: I’m thinking about a situation we have, unfortunately, an individual with a significant IRA is single, lost a spouse and has children that are very young. There, that’s the opportunity for the charitable remainder trust in spades. In other words, you would have multiple charitable remainder trusts for each of those young children and the distribution is spread over their lifetimes, not necessarily over the 10-year period. Putting in another way, you cannot express an absolute rule in this area. The only thing constant in tax planning, taxation in general, is change. If you’re not equipped to handle change, I think you must stay away from these options. That’s been my experience, Chuck. People seem to go bonkers when you talk about trusts and how assets would be distributed, fiduciary rules and the like. Do you share that concern?

Chuck: Yes. First of all, there’s obviously tremendous complexity to tax planning. I think that most people who aren’t just completely immersed in it find all of these things just mind-bogglingly complex. Even though like most topics, once you immerse yourself, they start feeling a little simpler, but for people who are not, and that describes 95% of the population, this is just terribly complicated stuff. It is always changing and while my comment before was that I’m hesitant to plan based on what you think the change of the legislation is going to be, I think that you do have to plan for there being some– I don’t want anyone to misinterpret that comment as meaning that we believe that the legal landscape is going to be static because you know it’s going to change. It always does. The danger is if you try to predict what that change is going to be, because it will undoubtedly be something you haven’t anticipated. There has to be flexibility in whatever you’re doing as well.

Ed: I’m putting in another way. Stay away from the irrevocable, unchangeable, and modifiable changes that are in concrete. Try to remain as flexible as possible. Irrevocable transfers in light of what we’ll get into in terms of the economy are really difficult. I recall a story; it was involved in the transactions in Minnesota. Being the smartass that I can be most of the time, this thing with this gentleman who was selling these assets, there was this enormous debt like $2 million. I said, “Charlie, what’s the source–” This guy on the other side we were buying the asset. “What’s the source of this $2 million?” I had to ask that question. Charlie was the lawyer for the guy, and I didn’t want to talk to the client directly. Charlie said, “Well, that’s a gift tax that we incurred in making a gift of all these assets.” I didn’t say a word because what occurred was the assets precipitously declined in value. Those gift taxes were paid, and now he had to borrow money to pay them and the assets that were supporting that debt had gone down substantially. Putting in another way, lifetime irrevocable transfers versus a beneficiary change form in your IRA that you can revoke and change and modify is something that you must consider. Putting in another way, something that’s not changeable, that you can’t modify is something Chuck to be avoided, or am I off base here?

Chuck: Well, the example you just gave is also another version of avoiding the prepayment of the tax which is the second mistake that that particular party said. I think as a general rule, it’s a good one although there are some exceptions. We’ve just been talking about Roth conversions which is something that one could accuse you of prepaying a tax by doing a Roth conversion. The other thing is sometimes with these lifetime gifts, you’ll have the calculus being that the effective tax rate for a lifetime gift is lower than the effective tax rate for a transfer on death when you’re talking about somebody who has a taxable estate. Sometimes there’s savings involved with essentially prepaying a tax which always involves doing something that is irrevocable. I think that the general advice is sound, which is that you have to be very cautious and suspicious of any kind of plan that involves doing either those two things, and especially something that involves doing both.

Ed: Yes. One other hold we’ve got to address is tax basis step up. Let’s assume we have, again, a single individual. Let’s use round numbers or let’s assume the estate is $12 million and the cost basis for the property is all a bunch of shares of NewCo or a corporation that’s done very well over many decades is $2 million. There’s an untaxed gain of $10 million in this individual’s estate. If that transfer were made during the lifetime of this owner, the tax basis in the hands of the owner carries over into the hands of the donee. When the donee sells the assets during the donee’s lifetime, that tax measured at 20% plus 3.8% plus an estate tax on that $10 million is payable but if that individual had held those assets until it became a ghost, in theory, there is no tax on that $10 million. Putting it in another way, the idea of giving and receiving and how and when and why and to whom is not an easy decision. Has that been your experience Chuck? Moreover, no one wants to give away their assets. Let’s start with that.

Chuck: Right. Yes. There’s always hesitancy to be making gifts of assets of any substantial amount during life. I think that’s true for practically everyone. For most families these days, because the exemption amounts are now $11,580,000 for each individual, most people are facing the basis step-up that occurs at death. There’s a definite advantage and it’s not offset by any disadvantage of risking paying estate taxes. Although I guess, and maybe in one of our future podcasts, we might want to get into the question about the fact that these high exemption amounts are scheduled to be cut in half, and what kind of planning is appropriate with respect to that. Yes, for most people, the basis step-up is going to be the only tax implication associated with death. There’s not going to be an estate tax issue for most folks. That is definitely the right call.

Ed: Recall, in 2010 where we theoretically had no estate tax and George Steinbrenner, then-current owner of the New York Yankees died so there was no basis step-up, but on the other hand, his old basis carried over. We don’t lose sight of that. The heirs that inherited that property faced the estate tax on their ghost, but theoretically, there’s more than one and so you can divide that gain among various parties. The bottom line here is, again, I’m being redundant, but change is constant and the penalty, and there is a big penalty, for having accumulated more than round numbers, $12 million per person, is very severe in that you must keep up. You’re paying lawyers to do silly things perhaps. It doesn’t confer any real benefit to society. All you’re doing is avoiding the application, which really is a voluntary tax. In my view, this tax, the transfer taxes, unlike the income taxes, are voluntary taxes. Chuck, any comments about that? Maybe I’m overstating it.

Chuck: No, I don’t think you’re overstating it, although your comment could probably be confused in the sense that maybe it’s better to say they’re avoidable taxes because you certainly can avoid them. Although typically anyone who wants to avoid them is going to have to be willing to build their estate plan around the mechanisms that are required in order to do so. Quite often, especially the larger the estate is, involves including some charitable giving. That seems to be the bargain that the government has made here is, “Look, we’re going to create a taxing system here that has a lot of loopholes, but the biggest loopholes that allow you to avoid this tax involve you instead giving money to the government and trusting us to do something good with it, find a charity that you trust and give money to the charity instead.

Ed: Maybe it’s your own foundation, Chuck. Our donor-advised fund sponsored by some of the very large investment homes. I’m thinking of Schwab and Fidelity and Vanguard, have their own donor-advised funds in lieu of a foundation. Putting it another way, there is a toll charge. There’s absolutely a toll charge, but the other side is psychology. When I visit with folks, and I’ll say, “Pete, you got $40 million.” Theoretically, let’s assume we have a Pete with $40 million. “How much more do you need? How much more do you want?” Pete will always say, “Just a little more.” Fear, greed, the government, and revenge. I think of the best source of fee income is revenge, we’ve even had that as far back as the Illiad. We have Achilles after revenge. Putting it another way, the Four Horsemen are alive and well. Fear, greed, the government, and revenge and so you have to factor that into any plan. Having said that, I wish I had majored in psychology rather than whatever I did major in. Chuck, am I off base on this? I don’t know.

Chuck: No, you’re not off base. Getting back to your comment about there being a toll charge, these taxes can be avoided, but the thing that can’t be avoided, which really effectively is another tax, at least it’s another expenditure, is the legal and accounting costs that are associated. Once you have accumulated enough wealth that you’re above that rounding off about $12 million or so, you’re going to have to spend money on paying people to do the reporting that’s required even if the reporting involves reporting that everything went to a charity and so there’s no tax to pay. There’s no getting out of this without having some expenditures on board. That’s just the way it is.

Ed: There are friction costs and toll charges. The friction costs are the professionals who are obliged to monitor what’s going on whether it’s as trustee or tax return prepare. Then the real toll charge is the income tax that you would otherwise pay that’s now gets into the charity. This gets back to the suspension of the RMD and the whole nine yards. It’s a game, but fortunately, Congress has responded to the decline in the economy. Let’s talk about that and investing in turbulent volatile times like now. Any general observations care to express Chuck?

Chuck: Well yes. First of all, that is definitely exactly what this temporary relief from RMD is all about is the recognition that the required minimum distribution is calculated based on the value of the assets inside everyone’s IRAs as of 12/31. Subsequent to 12/31 we had a pretty substantial drop in the value of those assets and so Congress here is recognizing that you’re supposed to buy low and sell high and when you take a distribution from your IRA for most people, that involves inside the IRA selling assets. The risk here is that in order to comply with making that required minimum distribution the tax code was going to require people to sell low. Sell assets while they were at a low value which it just seemed like maybe that’s rubbing salt in the wound here that not only have you as the IRA owner incurred these losses in the values of your assets but then you’re going to lock in those losses by selling some of those in order to make this required minimum distribution and then turn around and pay income tax on the distribution. Of course, if you had large numbers of people doing that across the economy while the market was down, that selling pressure only serves to further deflate asset prices. This is a related issue and it really comes down to an investment management issue and the idea being that Congress doesn’t want to be forcing people to cash out of their retirement accounts at a time when the market is low because that’s just unequivocally bad investment advice which I think that we can almost immediately turn that around and say, “Well, if it’s unequivocally bad investment advice to be selling, doesn’t that mean it’s unequivocally good investment advice to be buying”. What do you think Ed?

Ed: Well, I agree, I’d be buying. The problem with that is if there’s no cash available you’re talking about a margin loan, and we get to the 80/20 rule that we’ve expressed on previous podcasts. In other words, you have $100,000, you can only sustain $20,000 in debt and you have $80,000 in equity. You look at your balance sheet and so you can preserve that ratio, but when we have a downturn that 80/20 all becomes maybe a 20/20, in other words, a ratio of 1:1 which is the worst thing in the world. The issue in investing outside of your IRA which is not transactions inside of that are generally speaking not subject to any tax, but outside is the buy and hold philosophy and that gets to the issue what should you be buying? Certainly, I’m not giving any investment advice. I’m the last one to suggest anything but having said that, one opportunity that’s always available is just look at, for example, the Vanguard model portfolios and you’ve got a dividend growth for example, and search and see what the top 10 holdings are. Number one and number two, think about what’s going on in the economy today and in the future. So, you design your portfolio with the top 10 holdings. For example, you would have Amazon. Pays no dividend so you’ve got to be a little careful. You’d have Apple, Microsoft, and Walmart. Now, I am not a fan of Facebook or, for example, Netflix, although that has outperformed everyone. The point in investing is always purchase stocks that represent a company which is a good solid company, has a return on invested capital. Any observations, Chuck? In buy and hold and you don’t have to have 150 issues in your portfolio but focus on those that over a long period of time, foreseeable future should weather the storm.

Chuck: My own experience has taught me that that I am not a stock picker or I’m not a good stock picker. So my own practice has been to essentially buy the market itself by using one of these index type funds or ETFs, that way whoever the winners are whether it’s going to be Amazon or Microsoft or whoever, they’re going to be embedded in that portfolio. There certainly are plenty of people out there who can outperform that. I just happen to not be one of them.  Philosophically, where I would be at on this is that the attitude towards investing in my mind is more important than the selection of the individual investments as long as you’re in the right market. I think the right market is the stock market versus getting into fixed income and that kind of thing. I say that just because philosophically if you’re investing, you should be investing for the long term, and in the long term nobody outperforms the stock market. Maybe that’s an oversimplification. I don’t know, is that an oversimplification, Ed?

Ed: No. I’ve been at this for more than five decades and I will tell you that you avoid friction costs. I constantly see folks coming in reviewing and hailing their investments, reviewing the marginal costs of this. I’ve seen up to 170 basis points for doing nothing, and I see multiple trades that do nothing except enhance the benefit to the large organization. I’ve always asked myself, “Wait a minute, what if you had purchased good stocks?” For example, Amazon, be careful, again, no dividends, and Apple and Microsoft, and Walmart. Those stocks have outperformed everything. Why? Because people are going to shop at Walmart. Amazon is going to be the ruler of the world, I think. So I tend to stay away from buying the whole market and I like to focus on, because I’m not skillful enough to look at 10, 15 issues, I just want to see four or five issues and then maybe use a margin and make sure the dividends cover the margin and leave it alone. Don’t look at it every hour, every day, every month. Look at it quarterly for example. Now, if you can sleep that way, if you can sleep notwithstanding, that’s a good deal, but most folks are not able to handle it and sleep. Well, when you’re my age, you figure, “Well so what? I lose it. That means the kids aren’t going to get as much. My wife’s not going to get as much. How much more do I want?” The answer always is just a little bit more. So, it’s a philosophical issue as we’ve discussed in previous podcasts. What is your tolerance for debt? Putting another way, what is your tolerance for pain, which is a function of the interest rate, your ratio of debt to equity, your station in life. What’s your objective? There’s so many variables going on in investing in and there’s no one simple size fits all. Now, Chuck, I don’t know.

Chuck: No, I agree. I want to get back to the issue that you mentioned a few minutes ago about we can say it’s good advice to be investing at a time after the market has dropped in prices, and yet the issue becomes getting your hands on cash or cash being available to make those investments. That’s a little bit of a head-scratcher for me, because one thing you always find when you look at economic indicators during recessionary moments like this is that saving rates will skyrocket. By savings rates, I mean, bank deposits will be going through the roof. It’s a little too early to see those statistics yet, but maybe by the time this recording is published, or at least within a few months, people will be able to look at these statistics. I can just about guarantee you that what we’re going to find is that the cash in banks, and the holdings of short-term US Treasuries and other cash and cash equivalent type assets, they’re going to be through the roof, which means someone is out there basically racing to cash at a time like this. The cash is there. It might not be in your hands, but somebody has it, and they’re loaning it out to others at extremely low-interest rates. Money is always out there in the marketplace somewhere. It seems to be a psychological issue that’s preventing that money from moving into these markets that are primed for growth.

Ed: It gets to the psychology of investing. It’s counterintuitive to buy when markets are going down, because you’re trying to pick the bottom and guess what, you’re not going to ever pick the bottom, nor can you ever pick the top. The point is, if you’re always investing, you’re eliminating the brain damage of making decisions that you bought, for example, Amazon 10 years ago, you leave it alone. There’s a good-sized gain in well it may pull-back, but it’s counterintuitive to borrow money or to use your cash to buy stocks when the stock market is declining. That’s just the way the world is, and which has no solution to that except discipline and objective. Having said that, Chuck, I’d like to address the folks’ attention to some publications that warrant your attention. Bogle’s book, The Little Book of Common-Sense Investing talks about index funds, which is one opportunity. Then we will post on the website Chapter five from I think a magnificent book. It’s sixth edition of Valuation by some folks from McKinsey & Company and, more specifically, chapter five. We’ll post that. That’s not to say that they have all the answers, but it’s a good summary for the stock market. The title of chapter five is “The stock market is smarter than you think.” In my case, I assume that everyone around me is smarter, so I’ve got to work a little harder and be a little luckier. The bottom line is, there’s no substitute for an independent evaluation looking in the mirror, who are you? What are your objectives? What do you expect? Then tempering all that with some readings, for example, A little Book of Common-Sense Investing and chapter five, but you must make your own decision. Never rely upon someone else to make your decision. Why? If it goes south, you’re mad at that person. If after an independent study, you’ve made the decision, and it goes south, so what? There’s a whole bunch of psychology involved aside from debt-equity ratios and nature of the investment and the like. Bottom line, when you make the decision, if it’s wrong, you can live with it but if someone else makes it for you, you cannot live with it. Is that fair, Chuck or maybe I’m overstating it?

Chuck: No. I think that that is fair. I think that you’ve also stated a philosophy that many people will hear, they’ll nod their head, but they’ll never actually really absorb that, internalize that in the way that is necessary in order to follow through on it. I think that if you’re a person who has that approach to not just investing but all kinds of things where, “Hey, look, I want to be essentially my own driver here and I’m willing to undertake risk and I’m willing to accept the fact that I’m going to fail from time to time,” then you’re likely to be making your own decisions here. There are a lot of people who just don’t, they just simply won’t. I can think about people who I know well who are definitely smart enough and analytical enough and have enough time to be able to poke through this stuff and make their own investment decisions. Yet I know to an empirical certainty that they will go to their grave having never done that themselves, always paying someone else to do that for them.

Ed: That’s unfortunate. The final Ed’s Rule of Thumb and rule of the road,  which is irrevocable, that’s the only thing in my life that’s irrevocable, is that when I’m I thinking about a decision, an investment, life-changing or whatever, I never act on the decision the day I think I want to make the decision. I always defer to the next day. You’d be surprised at the changes you’ll make. In the middle of the night, you’ll think about it, you’ll come out with perhaps the same decision, perhaps a different decision, but the bottom-line leaving it fester, leaving it set will always come out with a better decision. Putting it another way, make haste slowly. Chuck?

Chuck: I think that it’s an insightful discovery to realize how often your brain is doing its best work when it’s on autopilot and you don’t seem to be the one driving it. That’s a little bit of a humbling discovery, but it is true.

Ed: Yes. Make sure you surround yourself with people that are brighter and as my dad said to me, “Eddie, for you that’s not going to be difficult.” End of this story, unless you have something to add, Chuck?

Chuck: I do not.

Ed: Okay. We’ll talk to you folks next time. Best regards.

Chuck: Thanks.

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