A woman and her husband review their IRA balance while talking about their retirement plan.
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If you’re looking for a tax-smart way to handle required minimum distributions (RMDs), converting them to a Roth IRA isn’t an option.
It is relatively common for retirees to need a plan for their required minimum distributions. That’s especially true for households that don’t need their RMDs to cover living expenses and other spending needs. Although you can reinvest these withdrawals in taxable accounts, the IRS limits how you can fund tax-advantaged accounts like a Roth IRA.
One of those restrictions: You can only make IRA contributions with earned income. As a result, you cannot use RMDs to directly fund a Roth IRA.
A financial advisor can help you plan RMDs and figure out if a Roth conversion is right for you.
Required minimum distributions (RMDs) are the required withdrawals that must be taken from a tax-deferred retirement account beginning at age 73.
Beginning at age 73 (or 72, depending on your date of birth), the IRS requires that you begin withdrawing a minimum amount each year from your pre-tax retirement accounts, such as 401(k) plans and IRAs. The exact amount depends on your age and the amount in your portfolio. To calculate your RMD, divide your year-end portfolio balance by a published life expectancy factor.
For each year in which you do not receive the full benefit, the IRS will charge you a tax penalty of 10% or 25% of the amount not withdrawn. For example, suppose you don’t withdraw the required $10,000. You could face a tax penalty of up to $2,500.
The IRS requires you to withdraw RMDs from tax-deferred accounts because each withdrawal is a tax event that triggers income taxes. Because you’ve already paid taxes on the money in Roth accounts, the IRS doesn’t require you to take minimum distributions from them. But if you still have questions about RMDs, consider talking to a financial advisor.
For some retirees, the problem with a required minimum distribution is that they don’t need the money yet. This mainly occurs among people who already have sufficient income streams or among people who have multiple accounts and want to withdraw them one by one.
Although you have several options for managing these distributions, you cannot reinvest them in a Roth IRA.
You can only make IRA contributions with what is called “earned income.” This includes money you receive from wages, salaries, contract income and other forms of employment. You cannot make contributions to an IRA – whether a traditional or Roth account – from investment income, capital gains, or many passive income streams such as rental properties.
This means you’re free to get a job in retirement and put that money into a Roth IRA for later in life. However, you cannot withdraw money from a portfolio and transfer it to a Roth IRA or other form of tax-advantaged retirement account. The IRS fully discusses this limitation in Publication 590-A.
This topic can be confusing because of the overlap between a recording and a conversion. If you have a pre-tax portfolio such as a 401(k) or an IRA, you are allowed to move money directly into a Roth IRA in what is called a conversion. You withdraw a lump sum from a tax-deferred account, pay income tax on the amount, and deposit it into the Roth IRA.
However, the IRS specifically prohibits you from converting required distributions into a Roth IRA. You can convert money that is not a mandatory distribution, but the law is unequivocal that you cannot do this with an RMD. Navigating the IRS rules for RMDs and Roth conversions can be confusing, so you may want to consider contacting a financial advisor.
A woman is considering what to do with her RMD in the coming year.
So, what should you do instead? For retirees, there are a number of options for managing RMDs.
First, you can convert the rest of your portfolio pre-tax after meeting the RMD requirements. In any year with an RMD, the first dollars you withdraw from that account are treated as part of your RMD. Once you reach the minimum amount, you are free to convert the rest of your account (all or part) to a Roth.
Let’s say you have an RMD of $10,000 in a given year. You must first withdraw that $10,000 before you can convert the remaining eligible amount in your retirement account to a Roth IRA. As always, keep in mind that Roth income has a five-year cooling-off period, so make sure you don’t need this money right away. And if you withdraw any of the money you exchange before the five-year period is up, you could owe a 10% penalty on the money (unless you’re 59.5 or older).
Second, it is common for retirees to reinvest their minimum benefits. While you can’t put this money back into a tax-advantaged retirement account, you can put it into a taxable investment portfolio. The exact nature of these investments will vary depending on your financial strategy and needs. Some retirees may do well to invest for growth, putting money they don’t need into stock funds. Others may do well to invest for security, putting money they will one day need into bonds or annuities.
But if you need extra help reinvesting your RMDs, a financial advisor can help you create a plan to put this money to work for you.
You cannot reinvest required minimum distributions in a Roth IRA. Although you can convert any remaining amount of your pre-tax retirement account, the IRS specifically prohibits you from placing RMD funds into a tax-advantaged portfolio. However, RMDs don’t have to be the end all be all of your investing. You are free to invest this money in a taxable account at your discretion or convert your remaining IRA or 401(k) money into a Roth account after your RMD for the year is satisfied.
The RMD formula can be difficult to use, especially because the IRS “life expectancy factor” can seem very arbitrary at first glance. But figuring out what you need to withdraw is an important piece of the puzzle for your long-term retirement planning.
A financial advisor can help you plan and manage your RMDs. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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