If you're nearing retirement and have a large balance in a traditional IRA or 401(k), you may be worried about required minimum distributions (RMDs). RMDs begin at 73 or 75, depending on your year of birth. And they could cause you a massive tax headache.
By forcing you to withdraw a certain sum from your retirement savings each year, the IRS is also forcing you into a tax bill. And if you want to avoid RMDs or at least minimize them, you may be inclined to do Roth conversions ahead of when they begin.
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With a Roth conversion, you roll funds from a traditional retirement account into a Roth IRA. You're required to pay taxes on a Roth conversion the year you make it. But once that money lands in a Roth IRA, you can benefit from tax-free gains and withdrawals. And you won't have to withdraw a dime out of obligation to the IRS, since RMDs won't apply.
But if you're going to do a Roth conversion, it's important to avoid one big trap that could cost you in a serious way.
Make sure the numbers work in your favor
The goal of doing a Roth conversion is to pay less tax on your retirement savings. But if you end up converting at a higher tax rate than you'll have in retirement, you won't be doing yourself any favors.
Let's say you're single and earning $100,000 a year, and you're looking to convert a $1 million IRA over the next 10 years. If you convert $100,000 a year while earning your current salary, you'll pay a 24% tax rate on almost the entire sum you move over, based on current rates.
Now, let's say today's tax rates don't change and that in retirement, your only income outside of your savings is your monthly Social Security benefit of $3,000. That's an annual income of $36,000 a year.
With a $1 million IRA, an initial RMD at age 73 is only going to be about $38,000 for a total income of roughly $74,000. That puts you squarely in the 22% tax bracket.
As you age, your RMDs are apt to increase. The point, however, is that you may end up paying more tax on a Roth conversion than you'd pay to actually take your RMDs from your savings.
Look at the big picture
A lot of people fear RMDs and will do anything they can to avoid them. In reality, RMDs may not force you into a withdrawal decision you weren't already going to make.
In this situation, if you're looking at $36,000 a year in Social Security, chances are, you're going to want to tap your savings to some degree anyway. Maybe you'd be inclined to withdraw $30,000 a year but the IRS is forcing you to withdraw $38,000. That's an annoyance, but financially speaking, it shouldn't alter your plans or taxes too heavily.
That's why you shouldn't go into retirement assuming that RMDs are going to be a problem for you. They may not push you into a higher tax bracket, and they may drive up your taxes only marginally.
When RMDs can really become a problem is when you're sitting on a multimillion-dollar IRA or 401(k) and your RMDs alone are coming out at the highest tax bracket. In that situation, your RMDs could also result in higher Medicare costs thanks to the program's income-related monthly adjustment amounts, which are effectively surcharges on Part B and D premiums.
But if you have a more modest retirement account balance, don't rush into RMDs. Instead, make sure they pay off in terms of taxes and that they're the right choice for you.
