Retirement savers must contend with two different forces when attempting to maximize their nest eggs: inflation and taxation. And, while there’s little we can do to corral higher prices, we can minimize taxes by properly deploying our assets.
Vehicles like 401(k) accounts and IRAs help defer taxes to a later date. Meanwhile, Roth IRAs and 401(k)s provide tax-free investment growth with after-tax dollars. Using these accounts in unison can reduce your overall tax burden and provide more in retirement, especially once required minimum distributions come into play.
This article explores the followings:
What are required minimum Distributions (RMDs)?
Which accounts are subject to RMDs?
Using Roth conversions to minimize the tax burden of RMDs
Considerations for Roth conversions
Traditional IRA and 401(k) accounts provide tax savings on contributions up to certain limits. These qualified contributions are tax-deductible and pegged to inflation, so the limits are set to rise a good bit in 2023. Next year, an individual can contribute up to $6,500 to their traditional IRA and $22,500 to their 401(k) account and deduct the total amount from their taxable income.
If you’re over 50, you can use “catch-up contributions” to put another $1,000 into your IRA or $7,500 into a 401(k). However, the government doesn’t want this tax-deferred money just accumulating forever: If you have a retirement account like an IRA, you may be subject to a required minimum distribution (RMD) once you hit the age of 72.
Each year, you’ll need to draw down a particular percentage of the account or face an excise tax of 50% on that amount. Your annual RMD will vary depending on your age and the account size. So if you have an RMD of $10,000 and fail to take it, you’ll owe ordinary income taxes and an additional 50% on the $10,000 that should have been withdrawn.
The IRS has removed the 50% penalty for 2021 and 2022 missed RMDs for inherited retirement accounts (that fall within their 10-year rule). This was to alleviate confusion for 2020 beneficiaries regarding their RMD obligations following the Secure Act. Nevertheless, outside these particular circumstances, RMDs must be taken annually. You’ll need to take the first one by April 1st of the year when you turn 72. The second is due by December 31st of the same year.
That’s right: two RMDs in a single year to start. You can take the first RMD earlier than April 1st, but that’s the cutoff. Your distributions are considered taxable income, so you must factor them into tax planning conversations as well. Thankfully, the IRS website has tables for calculating annual RMDs, so you don’t need to do the math yourself.
Any account that allows tax-deferred contributions will likely be subject to RMDs. However, there is one noticeable exception. Roth IRAs and 401(k) accounts (which we’ll get into later). A few of the more common accounts that have RMDs include:
Roth IRAs are not subject to RMDs, making them a good retirement vehicle for reducing taxes. Additionally, if you use a Roth IRA conversion, you may be able to reduce the burden RMDs place on your nest egg. Another thing to consider is the IRS’s Aggregation Rules (which we’ll discuss in a bit). If you have several traditional IRA accounts, the Internal Revenue Service considers them to be a single vehicle.
So, RMDs must be made based on the value of all accounts, not just from each individual account. This can be used to a saver’s advantage by selling tax-efficient investments for distributions and allowing less efficient ones to continue accumulating.
Roth IRAs are funded with after-tax dollars, so assets in the account can grow free from taxation. Not only do Roth IRAs provide better tax incentives—they also have looser rules than their traditional brethren. For example, the basis of a Roth IRA (contributions minus investment growth) can be withdrawn at any time without tax or penalty. Plus, you can pull out $10,000 for a first-time home purchase and not face an early withdrawal penalty.
The most significant benefit of a Roth IRA might be the lack of RMDs. A traditional IRA forces you to withdraw money at age 72, but Roth IRAs can accumulate indefinitely (or at least until passed down to heirs). However, Roth IRAs have strict income limits on contributions. So, if you’re a high earner, you won’t be able to fund a Roth IRA. In 2023, Roth IRA contributions will phase out at $138,000 and be eliminated entirely at $153,000.
A Roth conversion allows savers to benefit from the tax advantages of Roth IRA accounts without actually contributing to them. When performing a Roth conversion, you’ll need to sell assets from a traditional IRA and transfer them to a Roth IRA. You can’t use RMDs in a Roth conversion, but you can reduce the tax burden of future distributions by converting a traditional IRA into a Roth account.
This is a taxable event, so make sure to have funds outside your retirement accounts to pay the conversion tax. A backdoor Roth conversion allows high earners to access Roth IRAs, but they must make a nondeductible contribution to a traditional IRA and then convert that to a Roth.
A Roth conversion doesn’t always make sense for every person, especially considering some of the above-mentioned rules. Before converting, consider the following:
When making a backdoor Roth conversion, you can easily get tripped up by the IRS’s aggregation rules. For instance, if you make a nondeductible contribution of $50,000 to a traditional IRA but have a different IRA with $100,000 worth of tax-deferred contributions, you won’t be able to use all $50,000 worth of after-tax dollars in a conversion. Only $16,500 will be considered nondeductible by the IRS, and you’ll owe conversion tax on the remaining $33,500.
You must own a Roth IRA for five years before withdrawing. This applies, even if you reach the withdrawal age of 59.5 before five years of ownership have passed. This rule goes for converted Roth IRAs as well: Any Roth IRA created via Roth conversion cannot be tapped until five years have passed, so consider your time horizons before performing a conversion.
If you want to convert a traditional IRA to a Roth after your 72nd birthday, you must take the RMD first (and then perform the conversion afterward). You cannot roll an RMD into a Roth conversion. However, an RMD can be distributed, taxed, and reinvested into a Roth IRA.
RMDs can be tricky to navigate. Deciding to hire a financial advisor can help to reduce your tax burden and give you more control over your savings. If you’re considering a Roth conversion—or you simply want to take RMDs in the most tax-efficient manner available—schedule a call with TrustCore Financial Planning today. We are a CERTIFIED FINANCIAL PLANNER™ in Brentwood, TN.
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