Required minimum distributions, or RMDs, are a problem for some retirees. If that’s your situation, a Roth conversion may help.
The benefit of moving your money from a pre-tax portfolio, such as a traditional IRA, to an after-tax Roth IRA means an end to RMD concerns. Because you’ve already paid taxes on the money in a Roth account, the IRS doesn’t require minimum withdrawals.
The disadvantage is that you have to pay taxes in advance when you convert the money. Depending on your tax situation, this could end up costing you more in the long run than the accumulated value of the RMD tax events.
For example, suppose you are 60 years old. In seven years you’ll retire and you’ll be sitting on a $1.1 million IRA. Should You Start Converting Money to a Roth Account to Avoid RMDs?
Here are a few things to keep in mind. And you can always talk to a financial advisor about your own situation.
Beginning at age 73, your pre-tax retirement portfolio is subject to a required minimum distribution or “RMD.” This is the minimum amount that you must withdraw from the portfolio each year and on which you must pay income tax. The goal is to ensure that you ultimately pay taxes on this money, and it means that retirees can’t just leave money unnecessarily lying around to accumulate value.
The amount you need to withdraw is based on the value of the portfolio and your age. The rule applies per portfolio, not per individual. For example, if you own both a 401(k) and a traditional IRA, you must take RMDs from both.
Take our case above. You are 60 years old and have $1.1 million in an IRA. Suppose you left that money alone, with no additional contributions and a balanced growth rate of 8%. At age 73, this IRA could be worth about $2.99 million, and the IRS would require you to withdraw $112,890 and pay at least $17,000 in taxes.
One way to avoid this is to roll over your money into a Roth IRA, since RMDs don’t apply to those accounts. If you have questions about your own retirement taxes, get matched with a fiduciary advisor.
A Roth conversion is when you move money from a pre-tax retirement portfolio, such as a traditional IRA, to an after-tax Roth IRA. There are two important advantages to this. First, you withdraw money from a Roth account completely tax-free at retirement. This includes both the profit and the principal amount. Second, Roth accounts are exempt from RMD rules. You can leave this money until you need it.
The biggest drawback to a Roth conversion is the upfront taxes. When you convert money to a Roth IRA, you must pay income taxes on the entire amount converted in the year you make the conversion.
For example, suppose you convert a $1.1 million IRA in eleven increments of $100,000 per year. As a single filer, that would add roughly $22,000 per year to your federal tax bill, without taking into account any other income or taxes, or the repayment of principal. By spreading out these conversions, rather than moving the money all at once, you keep your tax brackets lower and save significantly.
If you were to convert all at once, you would jump from the 22% federal tax bracket to the 37% tax bracket for a tax bill of more than $400,000. This compares to a total of $220,000 if you spread out the conversions.
To be clear, this is by no means a comprehensive analysis. It’s just to show that the opportunity cost for a Roth conversion is very real. A financial advisor can help you do your own math.
But even spread out, those conversion taxes are all capital that could have remained invested. You lose the potential returns this money could generate. On the other hand, you eliminate the tax bill on any returns your remaining money generates.
For this reason, the rule of thumb for a Roth portfolio is this: You will generally do better with a Roth portfolio if your current taxes are lower than they will be in retirementbecause you pay the lower (current) rate to save on the higher (future) rate. You will generally do better with a pre-tax portfolio if your current taxes are higher than in retirement because you are saving at the current (higher) rate and paying at the future (lower) rate.
Households nearing retirement should be especially careful with Roth conversions. Money placed in a Roth IRA must remain there for at least five years. This does not block your entire portfolio; other funds may be eligible for withdrawal at any time, but it is important to keep track of what money you move and when. Talk to a financial advisor about how a Roth conversion might fit your goals.
A Roth conversion works when your long-term tax savings offset the lost growth from the taxes you pay today. That usually happens when you pay lower rates now to save on higher rates later.
The actual answer will depend on many factors that combine to determine your tax profile, both today and in the future. For example, your actual conversion tax bracket will be based on your current income, so your conversion tax will likely be higher than $14,000. On the other hand, your retirement taxes also include Social Security and all other sources of retirement income, which will also increase these tax rates, reducing the after-tax value of leaving your money in place.
This is the area where you should sit down with a financial advisor and discuss the whole situation. Ultimately, however, the question will usually come down to a best possible approximation. If you think you’ll pay lower rates today, it’s probably a good idea to take the conversion and avoid expensive RMDs. If you think you’ll pay higher rates today, it’s probably a good idea to leave your money and take the cheaper RMD.
It’s not a science and there are many uncertainties, but with good advice you can make an informed decision. Get matched with a financial advisor to discuss your strategy to reduce taxes in retirement.
A Roth IRA allows you to avoid required minimum distributions, but at the cost of upfront taxes. When it comes to managing your RMDs, it’s important to figure out whether you’re going to spend more today to save some money in the future, or whether the upfront price tag is worth it.
Don’t let your RMDs surprise you. Use our handy calculator to find out exactly what the IRS expects you to get from your accounts so you can decide whether you need to start making changes to your accounts.
A financial advisor can help you draw up a comprehensive retirement plan. 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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The post I’m 60 with $1.1 Million in an IRA. Is it worth converting $100,000 a year to a Roth to avoid RMDs? first appeared on SmartReads by SmartAsset.
