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Required minimum distributions (RMDs) from pre-tax retirement accounts can have a number of unintended consequences. These mandatory withdrawals can push you into a higher tax bracket, reduce your investment flexibility, increase your Medicare premiums, and cause more of your Social Security benefits to be taxed.
If you plan to convert IRA funds into a Roth account, consider talking to a financial advisor about this.
Converting a traditional IRA to a Roth account means you avoid RMDs, but the costs are high. For example, moving $850,000 into a Roth IRA will trigger a huge income tax bill the year you make the conversion. There are ways to optimize this process, but there is still a lot of uncertainty.
Tax rules require that you begin withdrawing a certain amount from pre-tax accounts such as traditional IRAs and 401(k)s each year starting at a predetermined age. For someone who is currently 65, RMDs begin at age 73. This is not optional and there are severe penalties if you do not take RMDs exactly as directed.
Some people who already have sufficient income from other sources prefer not to take RMDs. The taxes that RMDs impose are one of the main reasons for this reluctance. The additional income from RMDs can push you into a higher tax bracket and significantly increase your tax bill.
For example, a retired single filer with $60,000 in taxable income after deductions falls into the 22% bracket in 2024 and would owe about $8,250 in federal income taxes. But if they had to take a $50,000 RMD, their taxable income would nearly double, putting them in the 24% tax bracket. This could more than double their tax bill to about $19,400.
These tax effects are not the only problem. Having to withdraw money on a schedule reduces your control over your hard-earned savings. The additional income may also increase Medicare Part B premiums and require taxes to be paid on a portion of Social Security benefits. RMDs even impact estate planning, because having to withdraw money and pay taxes on it reduces the amount you can leave to heirs.
But if you need some guidance in planning or managing your RMDs, consider reaching out to a financial advisor and talking about it.
Required minimum distributions (RMDs) add to your taxable income, increasing your tax bill in retirement.
With all this in mind, it may make sense to consider converting money from your traditional IRA to a Roth account. This can work because Roths are exempt from RMD rules.
However, conversion is not always the best strategy. One reason is that you now have to pay taxes on the money you move into a Roth. Converting an $850,000 balance to a Roth in 2024 could cost you more than $267,000 in taxes.
But with a different approach, gradually converting IRA funds over several years, you can manage the annual tax burden and potentially reduce your overall tax bill. Again, this isn’t always the best move for everyone, so it may be worth talking to a financial advisor about it.
To find out if a Roth conversion could work for you, first estimate your future income and taxes. For simplicity’s sake, let’s assume that your after-deductions taxable income is now about $50,000 per year and will likely remain at that level in retirement.
Now let’s estimate your RMD. Let’s assume your $850,000 IRA grows at 7% until you start taking RMDs at age 73. In that case, the IRS tables put the first year withdrawal at about $55,000. This will increase your annual income from €50,000 to approximately €105,000 and cause your tax bill to rise from approximately €6,000 to approximately €18,000.
Consider making a gradual conversion now with the goal of emptying the IRA at age 73. Assuming you earn 7% per year and convert $132,000 each year, your IRA will be nearly empty in eight years. Going forward, any Roth withdrawals you make will be tax-free.
The downside is that the annual conversions will cause your taxes to go up. Your current taxable income of $55,000, added to $132,000 in Roth conversions, yields an income of $187,000. This pushes you into the upper reaches of the 24% bracket for a single filer without putting you in the 32% tax bracket (which applies to incomes over $191,950).
However, you will pay about $25,000 in taxes on your first Roth conversion. Although tax rates are expected to change after 2025, if you paid $25,000 per year for eight years, your total tax bill for the conversions would be about $200,000. That’s less than you might pay if you converted the entire amount in one year. The question you want to answer, however, is whether this is less than what you would pay in taxes if you leave the money in a pre-tax account and take RMDs.
To ensure that the gradual conversions save you money in the long run, calculate how many years of RMDs it will take before your cumulative income taxes exceed $200,000. This calculation can be complicated, so it may be worthwhile to have a financial advisor do these projections for you.
Once you determine that breakeven point, you can assess whether you expect to live that long.
A man is looking at his retirement accounts on his laptop.
A big issue with Roth conversions is how you pay current taxes. In your case, you could take $25,000 a year from other sources, or use some of the converted money to pay the annual tax bill (since you’re over 59.5 years old). However, using converted funds will reduce the size of your Roth account and your future ability to make tax-free withdrawals.
This strategy requires making assumptions about earnings, revenue, and taxes that may not pan out. For example, if you are taxed at a lower rate in retirement than you are now, which is not unusual, you might be better off not switching now. However, before proceeding with either approach, consider talking to a financial advisor.
Converting money from an IRA to a Roth can save you taxes in retirement, but it will cost you upfront. You may be able to reduce the overall tax burden of a conversion by gradually moving the pre-tax money into a Roth account, but that’s not always the best move. There are significant uncertainties in using this maneuver, including challenges in predicting future income, investment returns, and tax rates. You may be better off if you don’t convert and take the RMDs as prescribed.
Social Security plays an important role in most people’s retirement plans. The age at which you file for benefits can have a major impact on your income prospects for the rest of your life. Claiming Social Security at age 62 will result in a 30% reduction compared to what it would be at your full retirement age (FRA) of 67. Meanwhile, delaying Social Security will reduce your benefit by increase up to 8% for each year after your FRA. (up to 70 years). SmartAsset’s Social Security Calculator can help you estimate how much your benefits could be.
A financial advisor can help you assess the pros and cons of Roth conversion. 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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