Required minimum distributions are a “surprisingly powerful” policy tool that can increase or decrease retiree spending, according to retirement researcher Michael Finke, and recent changes to RMD rules may be having unintended consequences.
With “fairly arbitrary and rapidly changing” RMD rules being the norm, Finke says, many retirees seem to be underspending, resulting in lower-than-necessary standards of living as well as tax inefficiency in legacy planning.
There are also big effects on government revenue stemming from how RMDs shape retirees' income and spending behaviors.
Finke explored these dynamics in a recent post on LinkedIn, in which he shares findings from a forthcoming paper developed by the Employee Benefit Research Institute in partnership with the Milken Institute. Finke also cited some of his own recent work done in collaboration with PGIM’s David Blanchett to underscore RMDs' outsize role in shaping decisions by savers and retirees.
“RMDs only take two pieces of information into account as a withdrawal rule — current asset balance and a measure of expected longevity,” Finke observed. “If balances are volatile, spending will be equally volatile, unlike traditional spending rules used in financial planning or annuities. This makes RMD spending a less than ideal income path.”
How RMDs Affect Spending
In his post, Finke considers the individual retirement account distributions of an average 71-year-old retiree.
In 2019, when the required beginning date for distributions was age 70.5 for traditional IRAs and 401(k) plans, 85.3% of 71-year-olds took distributions from their IRAs. Just 30% of 69-year-olds took a distribution.
In 2020, RMDs were suspended under emergency rules to confront the coronavirus pandemic. That year, just 39.9% of 71-year-olds took a distribution. To Finke, this demonstrates the power of RMDs to “encourage” distributions that may have been better taken earlier from an income efficiency perspective.
In 2021, when RMDs became mandatory again and the RMD age increased to 72 under the Setting Every Community Up for Retirement Enhancement Act, only 31.7% of 71-year-olds took a distribution.
“In other words, RMDs seem to be what motivates people to take money out of IRAs in retirement,” Finke says.
As Finke told ThinkAdvisor in a followup email, RMDs “psychologically give people a license to spend savings.”
“Extending the RMD age is popular with voters who seem to hate being forced to take money out of IRAs,” he wrote, “but it will also inevitably lead to underspending among early retirees and higher unintended bequests [being distributed from within IRAs], which are especially inefficient with the 10-year stretch.”
Finke’s and Blanchett’s work further shows that retiree spending also increases from qualified accounts when RMDs kick in. That is, retirees don’t typically just move RMD assets from an IRA to a savings account — they spend them.
“The IRS RMD rule is guiding the retirement spending path of many Americans,” Finke said. “Policies that change the RMD age can influence retiree spending — an important policy implication given the huge number of baby boomer retirees aged 65 to 72.”
What About Roth 401(k)s?
A related discussion is explored in a new blog post by Alicia Munnell, a senior advisor of the Center for Retirement Research. In her analysis, Munnell likewise considers the unintended consequences of a specific RMD policy change in the Secure 2.0 Act.
Among its more than 100 retirement-focused provisions, the legislation eliminated RMDs for Roth 401(k)s. As a result, people with money in these accounts never get the “spending prod” that the EBRI-Milken research shows is so important in encouraging distributions from taxable accounts.
“At first glance, that change seems relatively harmless," Munnell observes. "After all, the account holders paid taxes up front, so why force them to withdraw their money?”
What this rationale ignores, however, is that assets in the Roth-style accounts continue to generate tax-free returns, even after the account holder reaches 73, the age when RMDs kick in for traditional 401(k)s. As a result, continuing to save tax-free makes Roths considerably more valuable over increasingly lengthy retirements.
This isn’t necessarily a problem, Munnell notes, but does seem like an arbitrary and potentially unfair framework. Given the conclusions drawn in the EBRI-Milken analysis, RMD-free Roth 401(k)s are likely having an unintended repressive effect on the spending behaviors of millions of retired Americans.
“One argument for changing the RMD rules appears to have been to make the treatment of Roth 401(k)s consistent with the treatment of Roth IRAs, which have never been subject to RMDs,” Munnell adds. “Consistency is a good goal. Congress simply flipped the wrong way.”
Why? Because flipping that way costs the government money.
“Right now, even though 82% of employers offer a Roth 401(k) option, only 17% of participants take up the offer,” Munnell notes. “As more workers recognize the advantages of no RMD, that percentage will increase. As a result, the tax expenditure for retirement plans — a wasteful expenditure under any regime — will increase.”
If Congress is looking for money either now or in the future, Munnell concludes, introducing RMDs for Roth IRAs and restoring RMDs for Roth 401(k)s would not only make the tax benefits fairer but also raise revenues: “That has to be a good thing!”
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