A lot of people I talk to get upset when they discover that they must begin taking required minimum distributions (“RMD’s”) from their traditional IRA’s beginning at age 70-1/2. They forget about all of the income tax savings that they’ve realized over the years from either making deductible IRA contributions or from making pre-tax contributions into 401(k) plans that they rolled over into their IRA accounts. This is especially true when they haven’t reinvested the tax savings from their deductible contributions which is fairly typical.
Moreover, many people don’t realize that IRS has authorized a deduction for their contributions in exchange for the right to tax distributions from their traditional IRA’s, whether voluntarily or via RMD’s. Whether or not you’ve taken any distributions from your IRA, beginning at age 70-1/2, you are required to take a minimum distribution each year from your traditional IRA accounts based on their value on December 31st of the preceding year and an IRS table life expectancy factor. The taxable portion of each distribution includes deductible contributions as well as earnings.
One way to “beat the system” and reduce, or potentially eliminate, your RMD’s is to do one or more Roth IRA conversions. Depending upon the amount of your Roth IRA conversion and your overall tax situation in a particular year, you may or may not incur tax liability in connection with your Roth IRA conversion. See The Ideal Roth IRA Conversion Candidate – Parts 1 and 2 and Two Great Roth IRA Conversion Candidates for strategies for reducing or potentially eliminating income tax liability in connection with a Roth IRA conversion. Whether or not you incur income tax liability, you will reduce your RMD amounts and eliminate them if you convert 100% of your IRA to a Roth IRA.
It’s important to keep in mind that by reducing or eliminating future RMD’s, you are doing so not only based on the current value of your IRA, you are also eliminating RMD’s attributable to future earnings. Furthermore, if you have children who will eventually inherit your IRA’s, you are reducing or eliminating their RMD’s as well.
To illustrate the potential power of elimination of RMD’s, I have prepared two spreadsheets as follows:
- Projected IRA Balances with Required Minimum Distributions (IRA #1)
- Projected IRA Balances Without Required Minimum Distributions (IRA #2)
The spreadsheets were prepared using the following assumptions:
- Traditional IRA balance of $100,000 at age 50
- Maximum annual contributions to traditional IRA’s from age 50 through age 69 on January 1st of each year
- Maximum allowable contributions of $6,000 increased by $500 per year every five years
- Earnings at 5%
- Withdrawals of required minimum distributions only on January 1st of each year beginning at age 70 through age 85 in IRA #1
Per IRA #1, after withdrawing RMD’s totaling approximately $404,000 over 16 years, the IRA is projected to be worth approximately $478,000 at age 85. Per IRA #2, with no RMD’s, the value of the same account is projected to grow to approximately $1.079 million at age 85. Depending upon the amount of income tax liability attributable to IRA #1’s RMD’s and what the IRA owner does with the after-tax distributions, i.e., spends or reinvests, would allow a more thorough comparison of IRA #1 to IRA #2. In addition, it must be kept in mind that in order to eliminate RMD’s, the owner of IRA #2 would need to do a Roth IRA conversion at age 69, and, in the process, increase taxable income in that year by approximately $494,000.
A Roth IRA conversion can provide you with an opportunity to reduce or eliminate your RMD obligation as well as that of your children if they will inherit your IRA’s. Before doing any conversion, however, a detailed analysis should be prepared to determine if the projected benefits to be derived from a conversion, including the reduction or elimination of RMD’s, is worth the cost, i.e., the tax liability attributable to the conversion.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.