The Little Known Tax Implications of Required Minimum Distributions (RMDs) in 401(k) Accounts
The Importance of Using Roth IRA Conversions to Reduce Required Minimum Distributions (RMDs)
On April 1st of the year following attainment of age 70 ½, you are required to start taking distributions from most traditional retirement accounts. You can always withdraw more, however you cannot remove less then the Required Minimum Distribution (RMD). The IRS will assess a severe penalty for the shortages—in most cases a 50% excise penalty on the amount not distributed.
The size of an RMD is calculated using the IRS Uniform Lifetime Table and the balance of your retirement accounts upon reaching age 70 ½. This is adjusted annually as your account balance and life expectancy decrease. This forces some retirees into a higher tax bracket by requiring the withdrawal of funds they may not need or would prefer to leave to a future generation. Thus, a strategy to reduce RMDs will reduce potential tax liabilities, create freedom for how you use assets, and help facilitate the transfer of wealth if you so desire.
Applying a Roth IRA Conversion Strategy
Unlike a traditional IRA, Roth IRA contributions are made after tax. There are several important factors that allow for high-impact retirement/tax planning. Contributions are nondeductible on your tax return, allowing you to pay the taxes on them now rather than later. You must have earned income in order to make annual contributions, currently limited to 100% of compensation up to a maximum of $6,000 annually plus $1,000 catch up for those age 50 and older. As with most rules, this one has an exception, the minimum does not apply to conversions!
So what is a Roth conversion? It’s a process by which you transfer assets to a Roth IRA from a Traditional IRA or other qualified plan, such as a 401(k). Roth IRA distributions are not tied to age or income level, allowing these assets to grow tax-free over time without any distribution requirements (no RMDs) giving you full control of those funds, forever!
Retirement assets held within qualified plans such as 401(k)’s or traditional IRA’s can be converted to Roth IRA’s. There is currently no limit to this conversion, however taxes must be paid on any amount converted at current ordinary income tax rates.
For most clients who are still working and currently in a higher tax bracket, the sweet spot to start conversions is just after retirement before RMD’s start. The conversions will be made at a much lower ordinary income tax rate. Consider the traditional retirement age of 65: this leaves five years available to do conversions, paying the taxes while you are in a lower tax bracket, reducing RMD’s significantly.
What about folks who are already over 70 ½? Conversions are still an option if you’re over 70 ½, however each taxpayer needs to assess whether the strategy will be effective. We can help with the analysis.
Income tax rates are likely to be higher in the future, increasing the importance of Roth Conversions now.
Roth IRA’s are a crucial component of a well-diversified portfolio. Considering that we currently have the lowest tax rates in generations, converting assets to a tax-free bucket has never been more cost efficient or important.