How Roth Conversions Can Reduce Future RMDs
Planning for retirement involves more than determining how much money you need to save. It also means considering how and when you will pay taxes on your retirement savings. One strategy that may help retirees manage future taxes is a Roth conversion.
Roth conversions can reduce future required minimum distributions (RMDs), potentially giving retirees greater control over their taxable income in retirement. However, the strategy requires careful planning because converting retirement savings to a Roth account can create a tax bill today in exchange for potential tax benefits in the future.
Understanding how Roth conversions work, when they may be beneficial, and what to consider before making a decision can help you determine whether this strategy belongs in your retirement plan.
What Is a Roth Conversion?
Many workers save for retirement through traditional 401(k)s and traditional individual retirement accounts (IRAs). Contributions to these accounts may receive an upfront tax deduction, and investments generally grow tax-deferred. However, withdrawals are typically taxed as ordinary income.
Eventually, most retirees must begin taking required minimum distributions from traditional retirement accounts. These withdrawals are generally required starting at age 73 under current law for people born in 1951 through 1959, while the applicable starting age is 75 for those born in 1960 or later. Certain employer-plan exceptions may apply. RMDs can create taxable income even when retirees do not need the money to cover their living expenses. IRS guidance.
A Roth conversion involves transferring money from a traditional IRA or an eligible retirement plan into a Roth IRA, subject to applicable rules. The amount converted is generally included in taxable income for the year of conversion, except for any portion representing after-tax basis.
In exchange for paying taxes on the converted amount now, investors may benefit from tax-free qualified withdrawals later. Unlike traditional IRAs, Roth IRAs do not require the original account owner to take RMDs during their lifetime. Qualified distributions are generally tax-free when the applicable requirements are met. IRS Publication 590-A.
This difference is what makes Roth conversions potentially valuable for retirement planning.
How Roth Conversions Can Reduce Future RMDs
RMDs are generally calculated using the balance of eligible retirement accounts at the end of the previous year and an IRS life-expectancy factor. The larger the applicable traditional retirement account balance, the larger the required withdrawal may be.
When you convert a portion of your traditional IRA to a Roth IRA, that amount is removed from the traditional IRA balance used to calculate future RMDs. Any subsequent investment growth on the converted assets also occurs within the Roth account rather than the traditional IRA.
Consider an example. Suppose a retiree has $800,000 in a traditional IRA and converts $100,000 to a Roth IRA. Before considering investment gains, losses, or other transactions, the traditional IRA balance would be reduced to approximately $700,000.
Future RMDs calculated from that smaller traditional IRA balance could be lower than they would have been without the conversion. The converted funds may continue growing in the Roth IRA without creating lifetime RMDs for the original owner.
The actual reduction depends on account balances, investment performance, the timing of the conversion, and applicable distribution rules. A conversion does not eliminate all future RMDs, and the remaining traditional retirement accounts will still be subject to the rules that apply to them.
The Potential Benefits of Roth Conversions
1. Greater control over taxable income
Traditional retirement account withdrawals can push retirees into higher federal income tax brackets. They may also affect how much of their Social Security benefits is taxable or trigger higher Medicare premiums.
By reducing traditional retirement account balances before RMDs begin, Roth conversions may help manage future taxable income. Roth IRA withdrawals that qualify as tax-free generally do not increase adjusted gross income, although other rules and income sources still matter.
2. More flexibility in retirement
Retirees who have substantial traditional retirement savings may eventually be required to withdraw more money than they need. That additional income can complicate tax planning.
Roth assets provide another source of retirement funds. Because original Roth IRA owners are not required to take lifetime RMDs, they can generally choose when to use those assets, subject to the rules governing qualified distributions.
3. Potential estate-planning advantages
Roth assets may also offer advantages when passing wealth to heirs. Beneficiaries generally receive Roth IRA distributions tax-free if the applicable requirements are met, although inherited Roth IRAs are still subject to distribution rules.
Reducing traditional retirement account balances may also reduce the amount of tax-deferred wealth heirs inherit. Whether that is advantageous depends on the owner's tax situation, beneficiaries' circumstances, and estate-planning goals.
The Risks and Costs to Consider
Although Roth conversions can provide long-term benefits, they are not automatically the right choice for every retiree.
The immediate tax bill. Converting traditional retirement savings to a Roth IRA generally increases taxable income in the year of conversion. A large conversion could push some income into a higher marginal tax bracket. Ideally, investors evaluate how much to convert without creating an unnecessarily large tax burden.
Medicare premium increases. Higher income can lead to Income-Related Monthly Adjustment Amounts (IRMAA), which increase Medicare Part B and Part D premiums for eligible beneficiaries. Because Medicare generally uses income information from two years earlier, a conversion today may affect premiums in a future year.
Other tax consequences. A conversion may affect deductions, credits, the taxation of Social Security benefits, and state income taxes. These effects should be evaluated together rather than considering the federal income tax bill alone.
The source of tax payments. Paying conversion taxes from funds outside retirement accounts may help preserve more money for future growth. Using retirement assets to pay the tax reduces the amount that remains invested and may undermine some of the strategy's benefits.
It is also important to remember that conversions generally cannot be reversed through recharacterization under current rules. Careful analysis before acting is essential.
Strategies for Making Roth Conversions More Effective
One approach is to consider conversions during lower-income years. For example, someone who retires at age 62 but delays Social Security and has not yet started RMDs may have an opportunity to convert portions of traditional retirement savings while taxable income is relatively low.
Rather than converting a large amount in one year, some retirees may benefit from spreading conversions over several years. This can help manage the tax impact and allow each year's conversion to be evaluated against the available tax brackets and other income considerations.
Another consideration is coordinating conversions with charitable giving. Retirees who are charitably inclined may be able to use qualified charitable distributions (QCDs) from eligible IRAs, generally beginning at age 70½, to support qualifying charities without including those distributions in taxable income when the rules are satisfied. QCDs can count toward an RMD when applicable, but they are not Roth conversions. Comparing these strategies may help determine the most tax-efficient approach.
Importantly, an RMD for a year must be taken before additional traditional IRA funds can be converted in that year. The required distribution itself is not eligible to be converted. IRS Publication 590-B.
Why Work With a Financial Advisor?
Roth conversion planning involves more than estimating future RMDs. It requires evaluating current and projected tax brackets, retirement spending, investment growth, Social Security, Medicare premiums, estate-planning objectives, and the availability of funds to pay conversion taxes.
A knowledgeable financial advisor can help model different conversion amounts and timelines, compare the potential costs and benefits, and coordinate the strategy with your broader retirement plan. Working with a tax professional can also help ensure that the proposed conversions fit your tax circumstances and are reported correctly.
The goal is not simply to minimize RMDs. It is to improve your overall financial position by balancing taxes paid today against potential taxes and flexibility in the future.
Actionable Takeaways
If you are considering Roth conversions as part of your retirement plan, start with these steps:
Review your retirement accounts. Identify how much you hold in traditional IRAs and employer-sponsored retirement plans.
Estimate future RMDs. Understand how your projected balances could affect taxable income in retirement.
Identify lower-income years. Consider whether the years between retirement and the start of RMDs may present an opportunity for conversions.
Calculate the full tax impact. Evaluate federal and state taxes, Medicare premiums, and other income-related consequences.
Consider partial conversions. Converting smaller amounts over several years may provide more control than a single large conversion.
Coordinate your strategy. Work with a financial advisor and tax professional to determine whether Roth conversions align with your retirement and legacy goals.
Roth conversions can be a valuable tool for reducing future RMDs and creating greater flexibility in retirement, but the best approach depends on your individual circumstances. With thoughtful planning, you can make informed decisions about when to pay taxes and how to position your savings for the years ahead.
Have questions about Roth conversions or your retirement strategy?
OpenAir Advisers can help you evaluate your options and determine how tax planning fits into your broader financial goals. Schedule a complimentary phone call to discuss your questions.
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