AAII, the American Association of Individual Investors

Converting to a Roth IRA Can Minimize RMDs

by Judith Ward

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The cost here comes in the form of a tax when money is withdrawn from these accounts.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.