When creating a Roth conversion strategy, many people believe that the ultimate goal is to avoid required minimum distributions (RMDs). While that’s admirable, there are many instances in which this goal simply isn’t achievable. Moreover, striving to avoid RMDs might come at the cost of what the true intention might be: To minimize the 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 strategy. Here are five things to look for when evaluating your personal situation.
Reason #1: You’re already taking money out of your retirement accounts for living expenses
If you’re relying upon your retirement accounts to cover your living expenses in retirement---congratulations! Your retirement accounts are doing what you originally intended. That is, you are using money that you’ve earned over your working years to support yourself after you’ve stopped working.
Sometimes, people let the ‘tax tail wag the dog.’ In other words, they feel so guilty about pulling money (and paying taxes on it) that 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 an IRA for living expenses. And odds are, your withdrawals will probably be more than the RMD, at least in the early years. If that’s the case, you’re not paying any more in taxes than you would have (the RMD is for the required minimum distribution—you can always withdraw more). So don’t worry about it.
Reason #2: You might not be paying as much in taxes as you think
This is often the case for several reasons:
- Lower tax brackets: For most people, your tax bracket in retirement is often lower than it was when you were working. This isn’t the case for everyone. For example, people with defined pension benefits or multiple sources of income might actually see more taxable income. However, since fewer employers offer defined benefit pensions than before, more and more folks are retiring without ever having the opportunity to participate in such plans.
- Distribution size: In the early years of withdrawals, the divisor used to calculate your RMD is larger, which means that your RMD is a fairly small amount of your IRA balance. As you get older, the divisor decreases, so each year, you’re required to distribute a larger percentage of your balance.
- For example, let’s imagine you turn 72 this year (first year of RMDs) and have an IRA worth $1 million as of December 31 of the previous year.
- Let’s assume that you’re using Table 1 (single life expectancy, which most people would use). 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.
3. Tax changes. At the time of this writing, there is a lot of speculation about tax code changes. We can’t do much about that, but there is a change that is already scheduled for 2022. Starting in 2022, the IRS will use a new, more favorable RMD table.
Using the example from #2, here’s how the RMDs would work under the new tables:
Divisor RMD Difference
Age 72 27.4 $36,496.35 $2,750
Age 80 20.2 $49,504.95 $3,971
While your RMDs still go up over time, the revised tables allow you to keep more of your 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 intend to make large charitable donations. The most tax-efficient way to do this would be through qualified charitable distributions (QCDs). Although you can start making QCDs at age 70 ½ (the old required beginning date for retirement account holders), you definitely can make QCDs at age 72 and beyond.
The beautiful thing about QCDs is that when you do them from a pre-tax account (you can do them from a Roth account as well, but it would not make sense), there are a couple of benefits:
- They offset your RMD (up to $100,000 per year), which means that your taxable income does not go up when the QCD leaves your account.
- You’re donating money that you have never paid taxes on. When you think about it, 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
Granted, it’s money that is not directly contributing 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, you might compare your tax situation to that of the people who stand to inherit your money. If they’re in a lower income bracket, you might decide to leave the money there. Of course, these things do change over time, so it’s worth keeping an eye on things as everyone moves through their respective careers. For example, your college student daughter might be in a much lower tax bracket today than she would be 10 years from now when she is finished with medical school and is a practicing physician.
Reason #5: Not doing Roth conversions might be the most tax-efficient plan for your situation
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 payments). 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 and 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:
- Doing some (but not all) Roth conversions
- 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.
Avoiding RMDs can be a prudent goal to strive for when creating a Roth conversion strategy, particularly 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.
Interested in reading more about Roth conversions? Check out Lawrence Financial Planning’s Roth conversions articles page. Here you’ll find lots of articles that we’ve written about Roth conversions. And if you’re ready to hire someone to help you create, implement, and maintain your Roth conversion strategy, contact us. At Lawrence Financial Planning, we would be more than happy to schedule a complimentary phone call to see how we can be of service to you.
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