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Service helps generate retirement income, avoid tax penalty

If you’re age 70-1/2 or older and have retirement savings in tax-qualified plans, such as a deductible IRA 401(k), 457(b) or 403(b) account or a Roth 401(k), the IRS could hit you with a substantial penalty if you don’t withdraw at least the minimum amount required by law on required minimum distributions (RMD).

Any amount you fail to withdraw to meet the RMD is subject to a 50 percent tax, so you don’t want to miss this deadline.

According to a Fidelity Investments, as of Dec. 6 nearly half (49 percent) of the financial firm's IRA customers have yet to take the full amount of the RMD for 2013. To respond to this challenge, Fidelity is offering an automatic service that will make the necessary calculations for you and make the payments at regular intervals. This can give retirees greater peace of mind that they won’t be penalized for noncompliance with complex IRS rules. Almost half of Fidelity’s IRA customers have already signed up for the automatic service.

A recent report by the Stanford Center on Longevity compared the RMD, which uses invested assets to pay you a retirement income each year over the course of your lifetime, to five other retirement income generators. The Stanford report shows that the RMD is one of several credible ways to generate retirement income, each having their pros and cons.

If you use the RMD to generate retirement income, you have the flexibility of access to your retirement savings and the potential for growth in income if your assets perform well, and any unused funds at your death are available for a legacy. An automatic service like Fidelity’s makes it easy for you to implement an RMD retirement income strategy.

It's important to note that the RMD isn't an annuity, so your retirement income under the RMD isn't guaranteed for life should you live a long time or experience poor investment returns. In addition, the amount of income can fluctuate from year to year, since it depends on the investment returns you experience during the previous year.

If you have substantial investments in stocks, the value of your assets could go up or down, resulting in gyrations in your retirement income from year to year. One way to address this volatility is to invest only a portion of your assets in stocks, say 60 percent or lower, and invest the remainder in less volatile assets, such as bonds. You could accomplish this with a low-cost balanced mutual fund or target date fund.

Another possibility is to use a portion of your savings to buy a fixed lifetime annuity that is protected from market downturns, with, for example, up to half of your savings. This type of annuity automatically complies with the RMD rules for the portion of your savings that’s invested in the annuity. You can then invest the remainder of your savings in a mutual fund and use the RMD to calculate your annual income from this portion of your savings.

This will dampen the volatility in your total retirement income when you consider the income from the annuity. The Stanford report shows that this hybrid strategy is a reasonable compromise between the two approaches of generating retirement income.

If you want to learn more about the details of the RMD rules, including how it’s calculated and exactly how and when it applies, please read my post from last year on the topic. It’s well worth any time you spend to understand how the RMD works, even if you choose to use an automatic service to implement the strategy.