I’m 60 With $1.1 Million in an IRA. Is It Worth Converting $100,000 Per Year to a Roth to Avoid RMDs?

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?

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. 

For example, say that you convert a $1.1 million IRA in eleven, $100,000-per-year increments. As a single filer, that would add roughly to $22,000 per year to your federal tax bill, not counting any other income or taxes, or return of principal. By spacing these conversions, instead of moving the funds in one lump sum, you keep your tax brackets lower and save considerably.

If you made a conversion all at once, you would jump from the 22% federal tax bracket to the 37% tax bracket for a tax bill of over $400,000. This is compared to a total of $220,000 if you spaced out the conversions.

To be clear, this is not a comprehensive breakdown by any means. It’s just meant to demonstrate that the opportunity costs to a Roth conversion are very real. A financial advisor can help you do your own math.

But, even staggered, those conversion taxes are all capital that could have stayed invested. You lose out on the potential returns this money could generate. On the other hand, you eliminate the tax bill on all returns that your remaining money does generate. 

For this reason, the rule of thumb on a Roth portfolio is this: You will generally do better with a Roth portfolio if your current taxes are lower than they will be in retirement, since you will pay the lower (current) rate to save on the higher (future) rate. You will generally do better with a pre-tax portfolio if your current taxes are higher than they will be in retirement, since you will save the current (higher) rate and pay the future (lower) rate.

Households nearing retirement need to be particularly careful with Roth conversions. Money placed in a Roth IRA must remain there for at least five years. This doesn’t lock up your entire portfolio, other funds may be eligible for withdrawal at any given time, but it will be important to track what money you move and when. Talk to a financial advisor about how a Roth Conversion would fit in to your goals.

A Roth conversion works if your long-term tax savings offset the lost growth from the taxes you pay today. That generally happens when you pay lower rates now to save on higher rates later. 

The actual answer here will depend on many factors that, together, create your tax profile both today and in the future. For example, your actual conversion tax bracket will be based on your current income, so your conversion taxes will likely be higher than $14,000. On the other hand, your retirement taxes will include Social Security and any other sources of retirement income, which will push up those tax rates as well, reducing the post-tax value of leaving your money in place.

This is the area where you need to sit down with a financial advisor to go over the whole situation. In the end, though, the question will usually boil down to a best-estimate approach. If you think that you will pay lower rates today, then it’s probably a good idea to take the conversion and avoid expensive RMDs. If you think you will pay higher rates today, then it’s probably a good idea to leave your money in place and take the cheaper RMD. 

It’s not a science, and there are a lot of unknowns, but with good advice you can make an informed decision. Get matched with a financial advisor to discuss your strategy to reduce taxes in retirement.

A Roth IRA will let you avoid required minimum distributions, but at the cost of up-front taxes. When it comes to managing your RMDs, it’s important to figure out whether you will spend more today to save a little in the future, or if the up-front price tag is worth it. 

• Don’t let your RMDs take you by surprise. Use our handy calculator to figure out just what the IRS will expect you to pull out of your accounts, so you can decide whether you need to start making changes to your accounts. 
• A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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