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Don't Make This IRA Mistake

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Nobody wants to pay taxes unless they absolutely have to -- especially those who are already retired and living on a fixed income. But like it or not, if you turned 70 before June 30 of this year, then you need to start taking money out of your IRA and 401(k) accounts -- or else face consequences you're not going to want to pay.

Paying the piper
There's no denying the incredible value that retirement accounts give investors. When you invest in a traditional IRA or 401(k), not only do you get an upfront tax break on the money you put into your account, but you also avoid having to pay any tax on the income that your investments pay along the way. Only after you start taking money out of your retirement account do you have to pay taxes on it.

As a result, most of the time, it pays to keep that retirement money untouched for as long as you can. But because Congress was smart enough to realize that investors would do exactly that, the laws governing retirement accounts include provisions that make you start taking money out of them, even if you don't need or want the money at that point. The law refers to taking required minimum distributions or RMDs, and although lawmakers gave investors a break from the RMD rules in 2009 following the market meltdown, they're back with a vengeance this year.

What do you have to do?
The first step is figuring out whether you're covered by the RMD rules. In typical Internal Revenue Service fashion, the rule is complicated: If you'll be age 70 1/2 by the end of 2010, then you'll need to take an RMD. Most people have to take those distributions by Dec. 31, although if you just turned 70 1/2, you have until April 1 to take the RMD. In addition, if you've inherited an IRA, you may need to take RMDs regardless of your age.

Second, you have to figure out how much you need to withdraw. Calculating the amount requires you to add up all your retirement account values as of the end of 2009 and then divide by an age-based life expectancy factor provided by the IRS. This factor changes every year, but if you're in your 70s, you can expect to have to withdraw around 4% to 5% of your total retirement account assets.

To make sure you take your RMD, the IRS hits those who don't with a huge penalty: 50% on the amount you should have withdrawn. So you definitely don't want to goof this law up.

Investing for RMDs
One of the key problems that many retirees face is coming up with enough cash to cover their RMDs. With bonds and bank CDs paying low interest rates right now, typical investments are going to force you to invade principal just to comply with the law.

One answer is to invest in dividend-paying stocks with yields high enough to match up with your RMD factor. Altria Group (NYSE: MO  ) , Exelon (NYSE: EXC  ) , and Verizon (NYSE: VZ  ) are all solid stocks with a history of financial strength, allowing even retirees to feel pretty comfortable owning them. And because each of them has a dividend yield above 5%, their dividend payments will go a long way toward getting your RMD paid for.

But going overboard can be a mistake. Cellcom Israel (NYSE: CEL  ) and Hatteras Financial (NYSE: HTS  ) , for instance, both yield more than 10%. But retired investors have to be concerned with stability. With Cellcom Israel paying more in dividends than it earns, and Hatteras tied to an interest rate environment that's in flux right now, retired investors may want to stay away from those ultra-high-yield stocks.

If dividends aren't enough, then you'll have no choice but to sell shares of stock. But that can be an excellent opportunity to rebalance your overall portfolio. For example, Netflix (Nasdaq: NFLX  ) has skyrocketed this year on strength in its subscriber base and the success of its streaming video platform. Chipotle (NYSE: CMG  ) has surpassed even the most optimistic projections, with analysts now calling for 38% earnings growth for this year and 20%-plus growth rates between now and 2015. If you own either of these stocks, trimming back can not only reduce your concentration risk but also provide the cash you need to take your RMD.

Don't forget
So if you haven't yet taken your RMD for 2010, take a close look and see if you fall under the provisions of the law. If so, this is money you definitely can't afford to pass up.

Even if you don't need to take an RMD this year, you still have to take care of your retirement savings. For some tips on doing exactly that, click here to read the Fool's new special report, The 7 Secrets to Salvage Your Retirement Today.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger thanks his mom for introducing him to RMDs. He doesn't own shares of the companies mentioned in this article. Chipotle is a Motley Fool Rule Breakers pick and a Motley Fool Hidden Gems selection. Netflix is a Motley Fool Stock Advisor recommendation. Cellcom Israel is a Motley Fool Global Gains pick. Motley Fool Options has recommended writing covered calls on Exelon, which is a Motley Fool Inside Value recommendation. The Fool owns shares of Altria Group and Chipotle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy saves you from mistakes.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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4/17/2014 4:01 PM
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