White Paper: A Simple Approach to Managing an Inherited IRA

America is currently at the beginning of the greatest wealth transfer in human history. 1 Increasing numbers of young people will be inheriting Individual Retirement Accounts (IRA’s) from parents and grandparents, as the past decades have seen Americans relying more on their individual savings and investments. As anyone with an inherited IRA knows, they follow slightly different rules from other inherited assets. For one thing, they come with Required Minimum Distribution (RMD) rules. Meeting those RMD’s year after year can seem nerve-wracking, but there are simple techniques that anyone can use to meet them while keeping the focus on growing the account balance. We’ve come up with one we like to call the RMD Ladder.

Laddering is the practice of breaking up a sum of money into multiple scheduled pay-out investments. This method became particularly popular during rising rate periods in the 70’s and 80’s, and we’re expecting we’ll be hearing more about them again as we appear to be entering a rising rate period once again. Typically, bonds or CD’s are used, as they mature at reliable dollar amounts and at predictable times. 

In an example of a bond ladder, an investor has $50,000 to invest in bonds. Instead of simply buying a $50,000 bond investment with one risk-profile, the investor breaks the sum into 5 equal amounts of $10,000 and invests them in bonds with 5 different maturity dates. Every year, one of those $10,000 sums matures, and the investor reinvests the matured sum in a new bond 5 years out. This way, interest rate and inflation risks are managed and the investor isn’t required to make a bet on the direction of interest rate policy. 

The RMD Ladder resembles the classic bond ladder above, but instead of reinvesting the matured sum, the investor distributes that matured sum from the IRA (or other RMD mandated account). Every year, a small amount can be taken from the most profitable investments in the portfolio and invested in the furthest out date- let’s say 5 to 7 years out. This way, many years of RMD’s are always lined up. It also guides decisions about annual portfolio rebalancing naturally.

This method allows the investor to manage the need for money to distribute with one hand while managing the rest of the portfolio for the long-term with the other. The amount that isn’t exposed to RMD requirements for the next 5 to 7 (or more, if you’re very conservative) can be invested in riskier investments that might otherwise have to be sold at the wrong time for a bad price. Imagine having to have met an RMD by selling your stocks during 2008: the longevity of the asset base of the portfolio would have been negatively impacted.

While this strategy might seem applicable to any IRA, in practice it often isn’t for IRA’s for retired investors. By that time, investors should typically be taking much less risk anyway. The income from portfolios heavily positioned in less risky investments usually is enough to meet RMD’s. For younger investors who likely should be taking the most risk they will take in their lives who also have an inherited IRA, the RMD ladder makes much more sense.

Fortunately for younger investors, we now have Exchange Traded Funds (ETF’s). Bond ladders take large sums of money to construct because individual bond investments typically require around $10,000 per position. By contrast, a Target Maturity Bond ETF can be bought for as little as $25 or less per share. This makes it simple to build RMD ladders for portfolios of almost any size. What’s more, depending on the Brokerage the investor uses, some of these ETF’s have their commission’s waived (Schwab currently does this for Guggenheim’s target date ETF’s, for instance). It’s never be easier to manage a portfolio with this approach.

The RMD Ladder can be an easy place for even inexperienced investors to start with an inherited IRA. The sum that isn’t exposed to the RMD cycle can be managed with a simple mix of broad Equity and Fixed Income (bond) investments in Index Funds or ETF’s to start with. It can be used for the simplest portfolios imaginable just as well as the most complicated styles. In fact, it benefits investors who want to grow into owning higher risk investments with little liquidity, as the greatest benefit of the RMD Ladder is the management of liquidity risk. With the expansion of investment products covering more specialized needs every year, I expect the ability to manage portfolios in this style to be even simpler in the coming years.