The Tax Planning Benefits of Roth IRA Conversions
There are several reasons one should consider converting their Traditional IRA to a Roth IRA. It could create significant tax benefits, help reduce or eliminate required minimum distributions (RMDs), and can even provide benefits in your estate planning.
Let’s Start with RMDs
If you’ve reached Milestone 5 on the Next Dollar Roadmap and are actively saving for retirement in tax-advantaged spaces, odds are you will one day be faced with required minimum distributions (RMDs).
An RMD is a sort of line in the sand for the IRS. Since many retirement vehicles hold tax-deferred dollars that have been sheltered from Uncle Sam for years, a person’s RMD is the government’s opportunity to collect its due.
So, in the year you turn 72*, you’ll be forced to remove money from your tax-deferred retirement account (IRA, 401(k), 403(b), 457, and some others) at a required minimum amount based on life expectancy tables created by the IRS.
RMDs, like all Traditional IRA, 401(k), 403(b), or 457 withdrawals, are subject to income taxes at the account owner’s marginal tax rate.
If you fail to take your RMD, you’ll owe a 50% penalty** for the amount you missed. Needless to say, that’s a hefty price to pay so be sure you get those RMDs done.
Currently, the first RMD is just under 4% of the account balance and increases as a percentage ever year until you die. The RMD is never more than 50% of the account balance though, so you’ll never be forced to completely empty the account (though your heirs will).
(*Note: This RMD age is shifting with the passage of Secure 2.0.)
(**Note: This penalty is decreasing with the passage of Secure 2.0.)
The Average J IRA
We’d like to illustrate how RMDs work using our old friend Average J.
Average J turned 72 this year with an IRA account balance of $426,070 at the end of the tax year (Based on 2019 Fed data). Using the IRS’ Uniform Lifetime Table, Average J divides his account balance at the end of the year by 27.4.
This means Average J will have to withdraw $15,550 as an RMD from his IRA by the end of the year ($426,070/27.4).
Here’s the rest of the table in case you don’t want to bother with the link:
Age | Distribution Period (Divisor) | Age | Distribution Period (Divisor) |
72 | 27.4 | 97 | 7.8 |
73 | 26.5 | 98 | 7.3 |
74 | 25.5 | 99 | 6.8 |
75 | 24.6 | 100 | 6.4 |
76 | 23.7 | 101 | 6 |
77 | 22.9 | 102 | 5.6 |
78 | 22 | 103 | 5.2 |
79 | 21.1 | 104 | 4.9 |
80 | 20.2 | 105 | 4.6 |
81 | 19.4 | 106 | 4.3 |
82 | 18.5 | 107 | 4.1 |
83 | 17.7 | 108 | 3.9 |
84 | 16.8 | 109 | 3.7 |
85 | 16 | 110 | 3.5 |
86 | 15.2 | 111 | 3.4 |
87 | 14.4 | 112 | 3.3 |
88 | 13.7 | 113 | 3.1 |
89 | 12.9 | 114 | 3 |
90 | 12.2 | 115 | 2.9 |
91 | 11.5 | 116 | 2.8 |
92 | 10.8 | 117 | 2.7 |
93 | 10.1 | 118 | 2.5 |
94 | 9.5 | 119 | 2.3 |
95 | 8.9 | 120 and over | 2 |
96 | 8.4 |
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At the end of the next tax year, Average J will repeat the process and continue to do so for years until his death or until the balance is kaput.
So, Curt, what does this have to do with conversions to a Roth IRA?
Why Roth IRA Conversions Might Make Sense
In Average J’s case, $15,550 probably won’t move the tax needle very far in one direction or another, though it could matter.
In some cases, retirees don’t need income from their IRAs to live on, they want to preserve the balance for their kids, or the RMD will push them into a higher and less attractive tax bracket.
In any one of these cases or a combination thereof, converting the retirement account balance through a Roth IRA conversion before RMDs begin to occur would be advantageous.
Let’s look at another example to see how.
Converting to Avoid High Income Taxes
Assume Average J’s pal, Affluent Adam, is 62 and has a hefty Traditional IRA balance of $2,500,000.
In ten years when Adam turns 72, the account balance could be over $4,000,000 or more.
With a balance of $4,000,000, Adam’s IRA would be subject to a first-year RMD of $145,985.40. Currently, that would put Adam in the 24% bracket as a single filer.
However, Adam will also be collecting social security to the tune of another $42,000 annually pushing him into the 32% bracket. (We know it may be totally different in 10 years, but we’re going with what we know now.)
Adam’s annual expenses are only $80,000 even after 3 vacations and season tickets to see the Braves.
In summary, Adam will have to take out nearly $120,000 in income he doesn’t need, pay income tax on that amount in a high bracket, then find some other place to save it which could potentially expose investment growth to further taxes.
Don’t get me wrong, I don’t feel sorry for Adam either. He has a good problem, but he also has an opportunity to reduce his tax liability down the road by a significant factor using Roth IRA Conversions.
Here’s how Adam will save thousands.
First, Adam has enough money to retire and he’s tired of missing the daytime game down at Truist Park. Adam is going to go ahead and quit working at the end of this year.
Adam is already beyond the age of 59.5 and can begin making penalty-free IRA withdrawals, so he’ll take $80,000 out of the IRA and live on that and other money he has in savings.
Furthermore, because he won’t bump the 32% bracket until his income reaches $182,100, Adam can convert an additional $102,100 into a Roth IRA preventing that amount from being subjected to RMDs when he turns 72.
Adam will have to pay income tax on the converted amount. Part of the balance would be taxed in the 22% bracket, but the majority would hit at 24%.
That’s a high price to pay, but it would still save 8% on the portions that would be subject to the 32% rate in 10 years.
Also, that $102,100 can now grow tax-free in the Roth IRA instead of enlarging for the sake of fatter RMDs down the road.
In summary, Adam has reduced his tax-deferred account balance at a lower tax rate today than when he’ll be forced to take RMDs at a higher rate down the road.
You don’t have to be an IRA millionaire for this to make sense either. Many people retire early and intentionally live for years without realizing much or any income that is subject to taxes. This means they can convert IRA funds as low as 0%.
Click these links to learn more about progressive taxes and income taxes.
Converting for your Heirs
Another reason Adam may want to convert is for the sake of his heirs.
If you plan to leave an IRA balance to anyone other than your spouse, there’s no doubt they’d prefer to receive it as an Inherited Roth IRA as opposed to an Inherited Traditional IRA.
The reason is that non-spousal Inherited IRAs must be completely emptied within 10 years of the account owner’s death. Traditional withdrawals are subject to income taxes, but Roth withdrawals are not.
By converting your Traditional IRA to a Roth IRA, you ensure that your heirs won’t receive your IRA with a hefty tax liability attached.
One thing to consider in this situation is the tax status of your heirs. If you are in a very high bracket and they are in a low bracket, it won’t make sense to convert and pay the tax at your high rate so they can inherit less money tax-free.
If you’re unsure though, Roth IRA conversions ensure years of tax-free growth for your IRA that your heirs can enjoy (or at least the portion that’s left when you die).
Other Roth IRA Conversion Tidbits…
- There is a five-year rule that applies to Roth IRA conversions made before the age of 59.5. You won’t be able to withdraw converted funds for five years after the Roth IRA conversion or until you turn 59.5, whichever occurs first.
- You can convert at any age, but remember conversions to a Roth are a taxable event.
- If you think you will want to do Roth IRA conversions down the road, start putting away cash well in advance of the Roth IRA conversions so you can pay the tax bill instead of cannibalizing the Roth dollars to do so.
- If you’ve heard there’s a strategy for converting an IRA in order to obtain access to the funds before age 59.5, have I got a post for you. This strategy is called the Roth Conversion Ladder.
- Perhaps you make too much money to contribute directly to a Roth IRA and want to learn about using Roth IRA conversions for Roth savings. Backdoor Roth IRAs are covered in the linked post.
- There is no maximum limit on Roth IRA conversion amounts. If you can pay the tax, you can convert any amount to a Roth.
- Some of you were scoffing at Affluent Adam, failing to see how you could ever accumulate so much in an IRA that the RMD will be too much money for you. Well, if you’re saving 15%-25% of your income then you have a great shot of experiencing the same problem one day (albeit a good one to have). Those last years approaching retirement are when your savings will grow the most.
