Part 3 of this series discussed the first of three primary economic benefits to be derived from a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of Roth IRA conversion assets. As emphasized in the post, this is the most important and overriding reason in most cases for doing a conversion. The other two benefits are: (1) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA and (2) potential reduction in taxation of Social Security benefits. The second benefit is this week’s topic with the third benefit being the subject of Part 5 of this series.
Even though most people generally don’t celebrate half birthdays, Congress, in its infinite wisdom, decided for some reason, that two particular half birthdays are crucial as they pertain to income taxation of distributions from retirement plan assets – age 59-1/2 and age 70-1/2. Congress has determined that if you take distributions from a retirement plan, e.g., 401(k) plan, traditional IRA, etc., before age 59-1/2, this is too soon. If you dare to do this, subject to specified limited exceptions, in addition to paying income tax, you will be assessed a premature distribution penalty of 10% of the amount of your distributions. You may also be subject to a state-imposed penalty which is 2-1/2 percent in California where I live.
At the other extreme, Congress has mandated that 70-1/2 is the drop-dead age by which you must begin taking annual required minimum distributions, or “RMD’s,” from your various retirement plans. Up until this age, your employers and you have benefited by income tax deductions for contributions to your retirement plans and your assets have enjoyed the much-cherished benefit of tax-deferred growth. Beginning at age 70-1/2, it’s time for the government to begin receiving its share of your retirement assets.
If you’re not doing so voluntarily, at age 70-1/2, you must begin taking annual minimum distributions from your various retirement plans based on the value of your retirement assets on December 31st of the previous year and a life expectancy factor as specified in an IRS table. To the extent that either (a) you don’t take your “RMD” in a particular year or (b) the amount of your distribution falls short of your “RMD,” you will pay dearly. IRS’ penalty in this situation is onerous – 50% of the amount that you were suppose to take less the amount that you actually withdrew.
Even though I agree with Congress’ “RMD” justification and believe that the “RMD” tables are fair since they use a life expectancy that extends to 115 years, I personally don’t want to be forced to take X dollars from my IRA account in a particular year if I (a) have other more tax-favored retirement income sources to draw from and/or (b) don’t need the amount specified by IRS to meet my financial needs.
With foresight and proper planning, there is a way to reduce, or potentially eliminate, your exposure to “RMD’s” and associated forced taxation of retirement funds. That way, of course, is to convert a portion, or all, of your traditional IRA’s, including SEP-IRA’s, to Roth IRA’s. Roth IRA accounts are not subject to the “RMD” rules during the owner’s lifetime. While it’s a wonderful goal, reduction or elimination of “RMD’s” shouldn’t be the primary reason in most situations for doing a Roth IRA conversion. Generally speaking, it won’t make sense to pay income taxes today solely for the purpose of avoiding forced taxation of the same assets beginning at age 70-1/2.
As emphasized in Part 3, elimination of taxation on 100% of the growth of Roth IRA conversion assets is the most important and overriding reason in most cases for doing a conversion. To the extent that you’re able to achieve this goal while also minimizing your “RMD” exposure, more power to you!
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.