Required minimum distributions, or RMDs, are a problem for some retirees. If that’s your situation, a Roth conversion may be able to help.
The advantage to switching your money from a pre-tax portfolio, like a traditional IRA, to a post-tax Roth IRA is an end to RMD concerns. Since you’ve already paid taxes on the money in a Roth account, the IRS does not require minimum withdrawals.
The disadvantage is that you have to pay taxes up front, when you convert the funds. Depending on your tax situation, in the long run this may end up costing you more than the collected value of the RMD tax events.
For example, say that you’re 60 years old. Retirement is seven years away and you’re sitting on a $1.1 million IRA. Should you start converting money to a Roth account to avoid RMDs?
Here are a few things to consider. And you can always talk to a financial advisor about your own situation.
Starting at the age of 73, your pre-tax retirement portfolio is subject to a required minimum distribution or “RMD.” This is the minimum amount that you must withdraw from the portfolio and pay income taxes on each year. The purpose is to ensure that you eventually pay taxes on this money, and it means that retirees cannot simply leave unneeded money in place to accumulate value.
The amount you must withdraw is based on the portfolio’s value and your age. The rule applies per-portfolio, not per-individual. For example, if you hold both a 401(k) and a traditional IRA you would need to take RMDs from each.
Take our case above. You’re 60 years old with $1.1 million in an IRA. Say that you were to leave that money alone, with no additional contributions and a balanced, 8% growth rate. By age 73 this IRA could be worth about $2.99 million, and the IRS would require you to withdraw $112,890 and pay at least $17,000 in taxes.
One way to avoid this is by converting your money to a Roth IRA, because RMDs don’t apply to those accounts. If you have questions about your own retirement taxes, get matched with a fiduciary advisor.
A Roth conversion is when you move money from a pre-tax retirement portfolio, like a traditional IRA, to a post-tax Roth IRA. There are two main advantages to this. First, you withdraw money from a Roth account entirely tax-free in retirement. This includes both gains and principal. Second, Roth accounts are exempted from RMD rules. You can leave this money in place until you need it.
The main disadvantage to a Roth conversion is up-front taxes. When you convert money to a Roth IRA, you must pay income taxes on the entire amount converted in the year you make the conversion.