Roth conversions are a great way to avoid required minimum distributions (RMDs). Sometimes, an IRA owner who doesn’t need the money find themselves in a higher tax bracket when they have to take RMDs.
By having that money grow tax free in Roth accounts, they can protect themselves from higher tax rates. Furthermore, they can avoid the income-based surcharge on their Medicare premiums by keeping their taxable income low.
When creating a Roth IRA conversion strategy, many people believe that the ultimate goal is to avoid taking a required minimum distribution. But Roth conversions aren’t an ‘all or none’ game. From a financial planning perspective, focusing solely on this aspect might not make sense.
Moreover, striving to avoid RMDs might come at the cost of the bigger tax picture. Which should be to minimize federal income taxes you may pay over the course of your lifetime.
It can be hard to tell when it’s okay to allow for RMDs in your Roth conversion process.
Here are five things to look for when evaluating your personal situation.
Reason #1: You might be taking money from your retirement accounts for living expenses.
If you’re relying upon your retirement plan to cover your living expenses in retirement—congratulations!
Your retirement accounts are doing what you originally intended. That is, you did the following:
- Spent a significant amount of your life earning money.
- Instead of spending that money, you saved it.
- You invested for long term growth, so you could enjoy it in retirement.
Now it’s time to enjoy the money. One way to do that is to use it to pay for your retirement living expenses.
Sometimes, people let the ‘tax tail wag the dog.’ In other words, they feel guilty about pulling money out of their qualified retirement accounts.
Why? Because now they have to pay federal taxes on that money. So they shame themselves for missing the Roth conversion opportunities that they might have had.
But the truth is, many successful retirement plans often include periodic withdrawals from a regular IRA for living expenses.
Changes are that your retirement distribution will probably be more than the RMD anyway. This is especially true in the early years. If that’s the case, you’re not paying any more in federal income tax.
Just remember that RMD stands for required minimum distribution. If your financial plan involves taking more than the RMD, don’t worry about it.
Reason #2: Your tax liability might be lower than you think.
Many people worry that their tax bill goes up when they have to start taking RMDs. But there are many situations where this simply isn’t true.
There are several reasons why your bill might not go up that much in the tax year that you take your first RMD.
You might be in a lower tax bracket.
For most people, your tax bracket in retirement is often lower than it was when you were working. But this might not be the case for everyone.
For example, people with defined pension benefits or multiple sources of income might actually see more taxable income. However, fewer employers offer defined benefit pensions than before.
These employers now offer defined contribution plans. These are qualified retirement plans, like 401k plans, that the retiree has to manage.
As a result, more and more folks are retiring in situations where their qualified plan withdrawals might be their primary source of income. And it will probably be lower than when they were working.
Your withdrawals are lower in the earlier years.
In the early years of withdrawals, the divisor used to calculate your RMD is larger. This means that your RMD is a fairly small amount of your IRA balance. As you get older, the divisor decreases, which means you’re required to distribute a larger percentage of your balance each year.
For example, let’s imagine you turned 72 in 2020. That was your first year of RMDs. You had an IRA worth $1 million as of December 31 of the previous year.
Let’s assume that you’re using Table 1. This is the single life expectancy table most people would use, according to IRS rules.
That means your divisor is 25.6, so your RMD is $39,062.50 ($1 million divided by 25.6).
Let’s imagine the same scenario, but for an 80 year-old. Using the same table, the divisor is now 18.7, and the RMD is now $53,475.94 ($1 million divided by 18.7).
In your later years, you probably will be paying taxes on more of your IRA balance than you would be in your early years.
Changes in the tax rules are starting to recognize that people are living longer.
At the time of this writing, there is a lot of speculation about tax law changes. We can’t do much about that. However, there is at least one tax rule that benefits retired people.
The IRS has recognized that people are living longer. Which means that retirement plans need to last longer to support their living expenses.
In 2022, the IRS introduced a new, more favorable RMD table. This lowers the RMD amount in each year, so account owners can stretch them out over more years.
Let’s compare the exact same RMD under the new rules:
- Pre 2022 RMD Divisor: 25.6
- 2022 RMD Divisor: 27.4
- Difference in RMD on a $1 million account: $2,750
- Pre 2022 RMD Divisor: 18.7
- 2022 RMD Divisor: 20.2
- Difference in RMD on a $1 million account: $2,750
While your RMDs still go up over time, the revised tables allow you to keep more of your tax money growing in your retirement accounts, tax-deferred.
Now, let’s look at an instance where you might not pay taxes at all.
Reason #3: You plan to make large charitable donations
Perhaps you don’t need all of your hard earned money. Maybe your Social Security benefits and other sources of income are enough.
But you don’t want to pay additional tax on your earnings either. There could be another way to put your hard earned tax dollars to work.
You could start contributing some of that money to charity. The most tax-efficient way to do this is through what’s called a qualified charitable distribution (QCD).
You can start making QCDs at age 70 ½. Why 70 ½? Because before the SECURE Act, 70 ½ used to be the age that RMDs began. And when the SECURE Act raised the RMD age to 72, it left QCDs alone.
The beautiful thing about QCDs is that when you do them from a pre-tax account, there are several benefits.
QCDs offset your RMD. Every dollar that comes out of your IRA as a QCD is a dollar you don’t have to pay taxes on. So you still get to take advantage of that tax-free growth while supporting your favorite charity.
You’re donating money that you have never paid taxes on. When you think about how a QCD works, money in an IRA:
- Usually goes in pre-tax (unless you’re making nondeductible contributions)
- Grows tax deferred
- And is now being taken out tax-free
Technically, you can do QCDs from a nondeductible IRA or a Roth account. But that wouldn’t make sense from a tax planning perspective.
Granted, QCDs don’t directly contribute to your bottom line. But if you had intended to donate to charity, it doesn’t get any better.
Reason #4: Your heirs might be in a lower tax bracket than you
If you’re looking at the lowest overall tax bill, don’t forget your heirs. You might want to compare your income level to that of your beneficiaries.
Although you may want them to be able to make tax-free withdrawals, it might be better for you to let them inherit your traditional IRA assets instead. For example, if they’re in a lower income bracket, you’ll want to leave the money alone.
Of course, these things do change over time. It’s worth keeping an eye on things as everyone moves through their respective careers. Here are some things worth tracking:
- Marital status. Given the same income level, single filers pay more in income taxes than a married couple.
- Career progression. A student out of college is likely to be in a lower tax bracket than she would be 10 years from now.
- Tax law changes. Changes in the tax rules might have a significant impact on your Roth conversions. For example, the SECURE Act eliminated the ‘stretch IRA.’ Now, beneficiaries have 10 years to empty their inherited accounts.
- Future tax rates. With changes in the tax law comes changes in tax rates.
Reason #5: Not doing Roth conversions might be more tax-efficient.
When doing Roth conversions, you want to avoid a large conversion in any one year. That might result in additional conversion taxes you could otherwise avoid.
At the same time, you might not have much opportunity to make Roth contributions later in your career, if you’re above the income limits. At best, you might be able to make an after-tax contribution to a non-deductible IRA.
For most situations, there is a sweet spot for doing Roth conversions. That sweet spot usually exists between retirement and age 70 (when you maximize Social Security benefits).
For a lot of people who retire in their late 50s or early 60s, there is plenty of opportunity to do Roth conversions.
However, there are any number of instances where this opportunity doesn’t occur. Here are a couple:
- You have an enormous amount of pre-tax retirement savings. You simply might not be able to convert EVERYTHING at the ideal tax bracket.
- You retire later (in your late 60s), or not at all. In this case, you might not dip down to a lower tax bracket. You might not have an opportunity to do tax-efficient Roth conversions.
- You have significant amounts of income from multiple sources. This happens to executives with deferred compensation, incentive stock options, or other executive compensation plans. It also happens to people with defined benefit pensions or significant amounts of passive income (like from rental real estate).
In any of these cases, you might simply be better off simply doing fewer conversions. Or maybe not doing any Roth conversions at all.
Just keep in mind that each Roth conversion strategy is unique to each person’s financial and tax situation.
How Do I Decide?
Your Roth conversion strategy is something you should discuss in depth with your tax advisor each year as you do your tax planning. A tax-focused financial advisor or tax professional can help you build your Roth conversion strategy around your specific situation. And most tax planning is done before you file your tax return.
While not every financial planner can give tax advice, they can help incorporate tax planning into your finances. By keeping up with changes in the tax rules, they make sure you have accurate information every year.
Your financial planner can also help you answer questions like:
- What investment products should go in my IRA vs my taxable account?
- How much should I convert in a given tax year?
- How should I pay taxes on the converted amount?
- How do I keep my adjusted gross income low?
Avoiding RMDs can be a prudent goal to strive for when creating a Roth conversion strategy. This is particularly true when it’s possible to do so at an ideal tax bracket.
However, it shouldn’t be the ‘end-all, be-all.’ There are many instances in which sticking to this plan might backfire. Just remember, there is no tax efficiency in creating higher taxes now just to avoid a possible small tax bill down the road.