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Converting to a Roth IRA Can Minimize RMDs

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This article originally appeared in the March 2015 issue of the AAII Journal.

Individual retirement accounts (IRAs), 401(k)s, and other qualified accounts are popular ways to save for retirement. Contributions effectively lower your taxable income, but as with any benefit there is usually a cost.

The cost here comes in the form of a tax when money is withdrawn from these accounts. Typically, the entire amount of the withdrawal or distribution is included as taxable income. Since the government wants to collect taxes on previously untaxed retirement savings, it requires you to take annual distributions beginning at age 70½ whether you need to or not. These mandatory withdrawals are known as required minimum distributions (RMDs).

For many investors, these withdrawals are needed to support their lifestyle in retirement, and they would take them regardless of whether the government mandated it. However, if you do not immediately need this money and would prefer it remain invested in a tax-deferred account, RMDs present an unwelcome tax liability.

Required minimum distributions can also push you into a higher tax bracket, increase your Medicare premiums, and subject more of your Social Security benefits to taxation. Ultimately, RMDs reduce your ability to manage your tax liability. This is why investors who may not need to take distributions from their qualified retirement plans at age 70½ may want to consider some strategies to reduce their future RMDs.

An analysis from T. Rowe Price examined how an investor who will not need the money freed up by RMDs may use Roth IRA conversions to lower his or her taxes. The study found that investors approaching retirement can preserve a greater portion of their assets and significantly reduce their tax bill by using a staggered conversion strategy to move some of their tax-deferred retirement assets into a Roth IRA.

Why convert to a Roth IRA? Unlike tax-deferred accounts, Roth IRAs are not subject to required minimum distributions. While contributions to Roth IRAs do not reduce current taxes, retirement withdrawals are not taxed as long as qualified withdrawals are taken after age 59½ and the account has been held for at least five years. Therefore, it’s one of the most effective tools to lower and potentially even eliminate required minimum distributions. The sooner it is deployed in advance of age 70½, the greater an impact a Roth IRA can have.

Roth IRAs are a frequently underutilized tool by investors in and approaching retirement. This is most likely because the Roth IRA is less than 20 years old, and many investors may have already established significant wealth in tax-deferred accounts when the Roth IRA was created.

Additionally, government regulations have made the Roth IRA less accessible to higher-income investors, by phasing out the ability to contribute to a Roth IRA based on income levels. However, beginning in 2010, investors of any income level are allowed to convert assets from a traditional IRA to a Roth IRA. This presents a backdoor option for higher-income investors to access the RMD-free retirement account.

Converting assets from a tax-deferred account into a Roth IRA can result in a large tax bill as the amount converted is considered taxable income. However, paying taxes upfront on a conversion can be advantageous for those who will be faced with unwanted RMDs.

  1. Rowe Price’s study evaluated four different scenarios for moving tax-deferred retirement assets into a Roth IRA on a staggered basis. Table 1 summarizes the results. The annual household income and conversion amount were specifically chosen to illustrate the maximum conversion an investor can make without being pushed into a higher tax bracket, based on the prevailing tax rates (as of the date of publication). Because the money converted into a Roth IRA will count toward taxable income, it’s important to make sure the conversion does not push the investor into a higher tax bracket.

In 2015, the 33% tax bracket is applied to income above $230,450 for married persons filing jointly. Tthe hypothetical investor’s taxable income is $230,000 when the conversion is added to his or her annual household income.

You also need to keep in mind the 0.9% Medicare tax that is applied to income over $250,000 for married couples who file jointly and applied to singles with an income over $200,000.

Table 1 shows that by the time the hypothetical investor reaches 95 years old, he or she would have approximately $4.4 million between the tax-deferred and taxable accounts, assuming none of his or her retirement assets were converted into a Roth IRA. The investor will also have paid $659,560 in taxes on his or her RMDs, which ranged from $48,168 to $126,224 and generated $13,487 to $35,343 in taxes each year.

Table 1

However, if the investor had begun converting $40,000 annually into a Roth IRA starting at age 55, he or she would have $800,000 more in assets by age 95, with more than $5.2 million between the Roth IRA, tax-deferred and taxable accounts. The investor’s tax bill would be over $300,000 less, with only $342,152 paid in taxes on the Roth conversions and RMDs.

While this strategy did not wholly eliminate the investor’s required minimum distributions, it did significantly reduce them. The investor’s RMDs ranged from $12,150 to $31,839 and generated $3,402 to $8,915 in taxes each year. He or she paid $11,200 in taxes each of the 15 years $40,000 was converted into a Roth IRA.

The advantages of the staggered Roth conversion strategy become less pronounced as an investor gets closer to age 70½, but still exist even when he or she is 65 years old. The investor would have an additional $170,490 in assets and would have paid over $63,000 less in taxes than if he or she had not done the staggered Roth IRA conversions.

For investors over age 70½ who are already taking RMDs they do not need and would like to reduce their tax liability, the staggered Roth IRA conversion does not generate the same advantages. The taxes they pay on RMDs are, for the most part, equal compared to the taxes they would pay on a Roth IRA conversion.

However, there are reasons for investors over 70½ to consider a Roth IRA conversion beyond the benefits of reducing or eliminating RMDs. Roth IRAs allow retirees over age 59½ who have held the account for at least five years to withdraw large sums of money, whether for a medical expense or home repair, without worrying about how the large withdrawal may affect their taxes and Medicare premiums.

Additionally, the Roth IRA can be a powerful estate planning tool, as it enables investors to leave money to their heirs completely tax-free while reducing the size of their own estate.

A staggered Roth IRA conversion strategy may make sense for many investors who may not need to spend all of their required minimum distributions.

However, managing the taxable income amounts and possible tax liability from year to year can present unforeseen challenges. Working with a tax professional to implement a strategy that can be tailored to your personal situation is recommended.

Judith Ward is a senior financial planner and vice president at T. Rowe Price Investment Services.

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