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IRAs Portfolio Strategies Retirement Planning

Converting to a Roth IRA Can Minimize RMDs

Gradually converting traditional IRA assets into a Roth IRA can both increase lifetime wealth and reduce the total amount of taxes paid.

by Judith Ward | March 2015

Over the past several decades, investors have enjoyed the tax benefits of using 401(k)s, individual retirement accounts (IRAs), and other qualified accounts to save for retirement.

Contributions effectively lower taxable income, but as with any benefit there is usually a cost.

The cost here comes in the form of a tax when money is withdrawn from these accounts. Typically, the entire amount of the withdrawal or distribution is included as taxable income. Since the government wants to collect taxes on previously untaxed retirement savings, it requires investors to take annual distributions beginning at age 70½ whether they need to or not. These mandatory withdrawals are known as required minimum distributions (RMDs).

For many investors, these withdrawals are needed to support their lifestyle in retirement, and they would take them regardless of whether the government mandated it. However, for investors who do not immediately need this money and would prefer it remain invested in a tax-deferred account, RMDs present an unwelcome tax liability.

Required minimum distributions can also push investors into a higher tax bracket, increase Medicare premiums, and subject more of their Social Security benefits to taxation. Ultimately, RMDs reduce investors’ ability to manage their tax liability. This is why investors who may not need to take distributions from their qualified retirement plans at age 70½ may want to consider some strategies to reduce their future RMDs.

An analysis from T. Rowe Price examined how an investor who will not need the money freed up by RMDs may use Roth IRA conversions to lower his or her taxes. The study found that investors approaching retirement can preserve a greater portion of their assets and significantly reduce their tax bill by using a staggered conversion strategy to move some of their tax-deferred retirement assets into a Roth IRA.

Why Convert to a Roth IRA?

One of the most effective tools to lower and potentially even eliminate required minimum distributions is the Roth IRA. The sooner it is deployed in advance of age 70½, the greater an impact a Roth IRA can have.

Unlike tax-deferred accounts, Roth IRAs are not subject to required minimum distributions. While contributions to Roth IRAs do not reduce current taxes, retirement withdrawals are not taxed as long as qualified withdrawals are taken after age 59½ and the account has been held for at least five years.

T. Rowe Price customer data shows that Roth IRAs are a frequently underutilized tool by investors in and approaching retirement.

While investors under age 34 had eight times more money in Roth IRAs than traditional IRAs, investors in their 60s had nearly three times more assets in traditional IRAs, as of December 31, 2014. The same trend is also seen with investors in their 50s, who had a third more in traditional IRAs than Roth IRAs.

This is most likely because the Roth IRA is less than 20 years old, and many investors may have already established significant wealth in tax-deferred accounts when the Roth IRA was created. Additionally, government regulations have made the Roth IRA less accessible to higher-income investors, by phasing out the ability to contribute to a Roth IRA based on income levels.

However, beginning in 2010, investors of any income level are allowed to convert assets from a traditional IRA to a Roth IRA. This presents a backdoor option for higher-income investors to access the RMD-free retirement account.

Converting assets from a tax-deferred account into a Roth IRA can result in a large tax bill, as the amount converted is considered taxable income. However, paying taxes upfront on a conversion can be advantageous for those who will be faced with unwanted RMDs.

T. Rowe Price’s study evaluated four different scenarios for a married hypothetical investor with an annual household income of $190,000 who qualifies for the 28% federal tax bracket, has $500,000 saved for retirement in a tax-deferred account and $130,000 in a taxable side account by age 54. The investor continues to contribute $6,500 annually to the tax-deferred account until age 65.

One scenario assumes the investor keeps his or her money in a tax-deferred account. In the other three scenarios, the investor converts $40,000 each year into a Roth IRA beginning at age 55, 60 or 65 and stops converting assets at age 70, when RMDs from the tax-deferred account would need to be taken.

The annual household income and conversion amount were specifically chosen to illustrate the maximum conversion an investor can make without being pushed into a higher tax bracket, based on the prevailing tax rates (as of the date of publication). Because the money converted into a Roth IRA will count toward taxable income, it’s important to make sure the conversion does not push the investor into a higher tax bracket.

In 2015, the 33% tax bracket is applied to income above $230,450 for married persons filing jointly (the hypothetical investor’s taxable income is $230,000 when the conversion is added to his or her annual household income).

Investors should also be mindful of the 0.9% Medicare tax that is applied to income over $250,000 for married couples who file jointly and applied to singles with an income over $200,000.

The taxable side account was used in the study to pay the taxes due on the conversion, as well as to invest the unneeded RMDs. It grew at a tax-adjusted rate of 4.32% annually, while the tax-deferred and Roth IRA accounts grew at 6% annually. For simplicity purposes, the study did not take into consideration other investment accounts or withdrawals necessary to maintain the investor’s lifestyle in retirement.

Table 1 summarizes the results. By the time the hypothetical investor reaches 95 years old, he or she would have approximately $4.4 million between the tax-deferred and taxable accounts, assuming none of his or her retirement assets were converted into a Roth IRA. The investor will also have paid $659,560 in taxes on his or her RMDs, which ranged from $48,168 to $126,224 and generated $13,487 to $35,343 in taxes each year.

However, if the investor had begun converting $40,000 annually into a Roth IRA starting at age 55, he or she would have $800,000 more in assets by age 95, with more than $5.2 million between the Roth IRA, tax-deferred and taxable accounts. The investor’s tax bill would be over $300,000 less, with only $342,152 paid in taxes on the Roth conversions and RMDs.

While this strategy did not wholly eliminate the investor’s required minimum distributions, it did significantly reduce them. The investor’s RMDs ranged from $12,150 to $31,839 and generated $3,402 to $8,915 in taxes each year. He or she paid $11,200 in taxes each of the 15 years $40,000 was converted into a Roth IRA.

The advantages of the staggered Roth conversion strategy become less pronounced as an investor gets closer to age 70½, but still exist even when he or she is 65 years old. The investor would have an additional $170,490 in assets and would have paid over $63,000 less in taxes than if he or she had not done the staggered Roth IRA conversions.

Table 1. The Benefits of a Staggered Roth IRA Conversion Strategy

The T. Rowe Price study evaluated four different scenarios for a married hypothetical investor with an annual household income of $190,000, who is in the 28% federal tax bracket and has saved $500,000 for retirement in a tax-deferred account and $130,000 in a taxable side account by age 54. The investor continues to contribute $6,500 annually to the tax-deferred account until age 65.

One scenario assumes the investor keeps their money in a tax-deferred account. In the other three scenarios, the investor converts $40,000 each year into a Roth IRA beginning at age 55, 60, or 65 and stops converting assets at age 70, when he or she would need to begin taking required minimum distributions (RMDs) from their tax-deferred account. The taxable side account was used to pay the taxes due on the conversion, as well as to invest the unneeded RMDs. The taxable account grew at a tax-adjusted rate of 4.32% annually, while the tax-deferred and Roth IRA accounts grew at 6% annually.

For simplicity purposes, the study did not take into consideration other investment accounts or withdrawals. The amounts shown reflect totals for the investor at age 95.

  No
Roth IRA
Conversion		 Staggered Roth Conversions
 
  Starting at
Age 55		 Starting at
Age 60
Starting at
Age 65
Total RMDs Taken $2,355,571 $621,973 $1,358,119 $1,928,986
Taxes Paid in RMDs $659,560 $174,152 $380,273 $540,116
Taxes Paid on Roth Conversions $0 $168,000 $112,000 $56,000
Ending Value of Tax-Deferred Account $957,744 $252,886 $552,198 $784,300
Ending Value of Taxable Side Account $3,458,633 $742,917 $1,883,085 $2,776,255
Ending Value of Roth IRA $0 $4,235,652 $2,398,578 $1,025,812
Total Taxes Paid on Retirement Accounts $659,560 $342,152 $492,273 $596,116
Total Value of Accounts $4,416,377 $5,231,455 $4,833,858 $4,586,867

 

Investors Over Age 70½

For investors over age 70½ who are already taking RMDs they do not need and would like to reduce their tax liability, the staggered Roth IRA conversion does not generate the same advantages. The taxes they pay on RMDs are, for the most part, equal compared to the taxes they would pay on a Roth IRA conversion.

However, there are reasons for investors over 70½ to consider a Roth IRA conversion beyond the benefits of reducing or eliminating RMDs. Roth IRAs allow retirees over age 59½ who have held the account for at least five years to withdraw large sums of money, whether for a medical expense or home repair, without worrying about how the large withdrawal may affect their taxes and Medicare premiums.

Additionally, the Roth IRA can be a powerful estate planning tool, as it enables investors to leave money to their heirs completely tax-free while reducing the size of their own estate.

See a Tax Professional for Assistance

A staggered Roth IRA conversion strategy may make sense for many investors who may not need to spend all of their required minimum distributions.

However, managing the taxable income amounts and possible tax liability from year to year can present unforeseen challenges. We recommend working with a tax professional to implement a strategy that can be tailored to personal situations.

Discussion

Robert Jarvis from GA posted over 11 years ago:

We began converting my wife's traditional IRA to a Roth, before she was required to take RMDs, a few years ago. Our conversion was staggered to prevent our combined income tax from exceeding 15%, the long term capital gains rate. She is now 100% in the Roth which is one less thing we need to worry about for estate planning purposes. And, the tax hit was not overly painful.


John Reed from CA posted over 11 years ago:

In 2001 when my IRA portfolio was at a low point from the stock market crash of 2000 I converted half my IRA to a Roth(age 61). This probably was too much because I was in the 39.1% tax bracket, but I rationalized it by believing the market was going to rise again(and it did). Then the crash of 2008 came along, and I found my wife and I were going to pay zero income tax and leave a lot of deductions on the table. I then began rolling over an amount so that our tax was exactly zero each year through 2014. I was able to roll over tax free approximately another $100,000. I project this will lower my RMDs and also protect my Social Security from being taxed as much. If I live long enough my high tax bracket in 2001 will pay off.


Thomas M. Cunningham from WV posted over 11 years ago:

I wonder where I could find the T Rowe Price study this article mentions? A reference would be helpful. I managed to find quite a few TRP articles on Roth, but not this particlar study.


Philip Beyer from FL posted over 11 years ago:

I have been converting roughly $40 to $60k per year for 7 years from my traditional IRA to a Roth. In April, with the assistance of my tax advisor's tax preparation software, we can model my upcoming year's tax liability in order to make an initial conversion. In October I update my tax data and model conversions of additional $10k to 50k. This data, although not exact allows me the opportunity to see the impact of additional conversions on Medicare premiums and if I have room to take long term capital gains or if I want to donate appreciated securities in my taxable brokerage account to mitigate a portion of my conversion.


Pravin Modi from NJ posted over 11 years ago:

Very interesting article. However, there are several hypothetical assumptions we make in any analysis to prove hypothesis. Take for an example, when an insurance agent presents an analysis on variable life insurance, he creates a picture of illusion of very large cash value that will help in retirement. In reality, it is nothing but building a castle in the sand!!!!!!!!!!! I believe this is a good idea and those still working should take advantage of converting 401K to Roth IRA alternate year so that you can have a bigger nest egg in your retirement.


Rob Gerritsen from PA posted over 11 years ago:

I have been doing staggered conversions for several years as I approach retirement. The key to the tax advantage in this strategy is that by paying taxes on conversions from non-qualified funds, you get to increase your qualified balances by the amount of taxes paid. Here is an example. Assumptions: 28% tax bracket, $200k in an after-tax account (non-qualified). $500K in an IRA. Since that IRA will be taxed as you withdraw, the after-tax value of your IRA is $360K and the after-tax value of your assets is $560K. If you convert $100K, you pay $28K in taxes, leaving you with $172K in your after-tax account, $400K in your IRA and $100K in your Roth IRA. The after-tax value of your IRA is $288K, so the after-tax value of your assets is still $560K. However, the after-tax value of your qualified assets has grown from $360K to $388K. You now have $28K more that can compound at tax-free rates. The tax advantage disappears if you pay the tax on your conversion from qualified accounts. That may still leave other benefits, e.g., if you expect your marginal tax rate to be higher in the future, and the advantageous treatment of Roth IRA's vs. regular IRA's when you die.


Harriet Gross from PA posted over 11 years ago:

i figured out a few years ago that converting was a big time losing proposition for me. this is the only article which mentions that maybe it's not a good idea depending on tax situation...tho should go into more detail. (articles elsewhere talk about it as if it's the next best thing to sliced bread; not necessarily true). given how much ira money i have: much of it from rollovers of 401ks=all pre tax money so all taxable: the rest in a traditional IRA FOR WHICH I HAVE NEVER TAKEN A DEDUCTION SO ONLY GAINS WILL BE TAXED, the tax hit would be enormously high and there's no way, given my age, that i could make up that difference b4 retirement. as it is, i've gotten destroyed the last 2 yrs with outrageous capital gains, even from funds which don't normally pay them. i will definitely be in a lower tax bracket when i retire so it made sense just to leave things the way they were. there was only one year where i could make a roth contribution so i did. so, converting is not always a good idea.


Fred from TN posted over 11 years ago:

I didn't realize how large RMD can be if your max all IRA/401k/403b etc options over a lot of years. So, a couple of my considerations are that I can delay my social security to the year I reach 70.5 and reduce my income(in retirement) to allow for more conversion to Roth's without getting into a higher bracket. After I take social security and have RMD(post 70) I will have less flexibility. Another issue is getting the cash to pay taxes. When I withdrawl from taxable accounts I have to consider the large capital gains and taxes I also owe on that. Third, I took an early pension from my employer that allowed me to take a higher early payout that dropped at 62. This helped reduce income during the conversion years.


John Reed from CA posted over 11 years ago:

Thanks Rob Gerritsen from PA - that is beautiful! The light turned on.


Perry from Michigan posted over 11 years ago:

Recognizing that the box describing the TRP study may not be complete, the apparent flaw - or rather the improbable in most cases assumption - in the analysis appears to be that "The taxable account grew at a tax-adjusted rate of 4.32% annually, while the tax-deferred and Roth IRA accounts grew at 6% annually." The difference in rates of course comes from reducing the 6% by the 28% tax on the return in the taxable account. But for how many is the assumption that they will remain in the 28% bracket till age 95, even assuming both that they live that long and that the tax rate statutes remain constant, realistic? The issue of if and when to convert is still very dependent on assumptions about annual rates of return and tax brackets, not just simple averages over 20 or 30 years, but year by year since compounding renders early negatives in the period considered followed by positives later in the period do not yield the same end of period results as an average of these rates.


Perry from Michigan posted over 11 years ago:

. . . since the principles of compounding do not render the end result of 1) early negatives and later positives the same as either 2)early positives and later negatives, or 3) average rates, the same.


John Flynn from FL posted over 11 years ago:

For me conversion makes sense to control RMD distributions. Hopefully, I won't need extra dollars in my seventies. If managed, the transfer of funds over a few years to control taxes on the amounts, you can gain the advantage of using IRA savings in a efficient tax manner, when you need it or just leave for future generations. In my case I hope the funds are not needed until 84+ and based on a present worth analysis I will get a 2.5 to 1 advantage over the RMD method.


William Krygsman from IL posted over 11 years ago:

I am in my late seventies and have regular IRA acounts(incl.spousal acct)which pays us RMD on a monthly basis. Can I just tell my broker to switch or make a conversion to Roth IRA's, although we established the IRA's some 15 years ago? It would indeed safe on paying the IRS?


Robert Randall from TN posted over 11 years ago:

Is this a practical idea for a couple in their 70s, long retired and taking annual RMDs of around $7000? Have always assumed IRAs of any flavor were only for the still employed.


JAG from PA posted over 11 years ago:

Good article, though I think the effect on social security taxation was very understated. This can be the biggest $$$ factor, as it can effectively raise your marginal tax rate by adding another 85% of your marginal tax rate. For details, see the white paper link about 3/4 down the page at http://www.news.prudential.com/article_display.cfm?article_id=7012 Or search for "james mahaney social security"


K Zetterholm from NY posted over 11 years ago:

The article states glibly: "For investors over age 70½ who are already taking RMDs they do not need and would like to reduce their tax liability, the staggered Roth IRA conversion does not generate the same advantages. The taxes they pay on RMDs are, for the most part, equal compared to the taxes they would pay on a Roth IRA conversion." This appears simplistic, and may actually be wrong if the investor has available money in non-tax-deferred accounts with which to pay conversion taxes. In fact, unneeded RMD money could be used. In this case the conversion would be equivalent to adding the amount of the tax to the tax-deferred account and allowing it to grow tax free forever after.


Jerry Mead from IL posted over 10 years ago:

I could be wrong but I think you have to take the RMD before you can roll additional IRA or 401K money to a Roth IRA. This could affect the taxable income would you would have after age 70.5 and of course more taxes paid. You should considering rolling to a Roth IRA before age 70 to reduce the additive effect of the RMD.


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