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.
A financial advisor can help you plan for RMDs and figure out whether a Roth conversion is right for you.
It is relatively common for retirees to need a plan for their required minimum distributions. This is especially true for households that do not need their RMDs to cover living expenses and other expenses. 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 using earned income. As a result, you can’t use RMDs to directly fund a Roth IRA.
What are RMDs?
Starting at age 73 (or 72, depending on your date of birth), the IRS requires you to withdraw 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 that you do not take the entire distribution, the IRS will charge you a tax penalty of 10% or 25% of the amount not taken. For example, say you do not take the required $10,000. You could face a tax penalty of up to $2,500.
The IRS requires you to take 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 have additional questions about RMDs, consider talking to a financial advisor.
Can You Invest RMDs in a Roth IRA?
For some retirees, the problem with a required minimum distribution is that they don’t need the money yet. This is especially true for people who already have sufficient income streams or who have multiple accounts and want to withdraw them one at a time.
While you have several options for managing these distributions, you cannot reinvest them in a Roth IRA.
Roth IRA Requirements
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 that you are free to get a job during retirement and put that money into a Roth IRA for later in life. However, you cannot withdraw money from a portfolio and roll it over to a Roth IRA or other type of tax-advantaged retirement account. The IRS discusses this restriction fully in Publication 590-A.
Conversions are also limited
This topic can be confusing because of the overlap between a withdrawal and a conversion. If you have a pre-tax portfolio, such as a 401(k) or IRA, you are allowed to move money directly to a Roth IRA in what is called a conversion. You withdraw a lump sum from a tax-deferred account, pay income taxes 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 required distribution, but the law is unambiguous 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 consulting a financial advisor.
Alternative Options to Roth IRAs and Required Minimum Distributions
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 pre-tax portfolio 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’ve met the minimum amount, you’re free to convert the rest of your account (in whole or in part) to a Roth.
Let’s say you have $10,000 RMD 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, remember 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 money that you convert before the five-year period is up, you may owe a 10% penalty on the money (unless you’re 59 ½ or older).
Second, it’s common for retirees to reinvest their minimum distributions. 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 based on your financial strategy and needs. Some retirees may be better off investing for growth, putting money they don’t need into funds with a heavy stock load. Others may be better off investing for safety, putting money they may need someday into funds with a heavy bond load 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.
In short
You cannot reinvest required minimum distributions into a Roth IRA. While you can convert any remaining funds from your pre-tax retirement account, the IRS specifically prohibits you from placing RMD funds into a tax-advantaged portfolio. However, RMDs do not have to be the end 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) funds into a Roth account after your RMD for the year is taken.
Tips for managing required minimum distributions
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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.
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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.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not subject to major fluctuations like the stock market. The trade-off is that the value of liquid assets can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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The post I Was Planning to Take My RMDs and Convert Them to a Roth, But Was Told I Couldn’t. Is That True? first appeared on SmartReads by SmartAsset.
