ROTH Conversions, RMDs, and Retirement Optimization

Would you benefit from converting some of your “traditional” retirement savings (think 401k or IRA) into a ROTH type IRA?  An overview of the strategy may be useful in making your own determination.

Traditional vs ROTH -- what’s the difference?
Contributions to a traditional IRA (or 401k, 403b, 457 plan…) have to potential to lower your taxable income in the year of the contribution, and may defer income taxes on gains while held inside the account.  When the funds are withdrawn, they are typically taxed as income at your marginal rate, and if funds are withdrawn before age 59.5, an additional 10% tax penalty may be assessed.

In contrast, contributions to a ROTH are made “after tax”, and so receive no income tax benefit in the year of the contribution.  Taxes on gains are deferred as with traditional IRA balances. But when funds are withdrawn, after age 59.5, there is no income tax due.

Let’s talk about RMDs a bit.
The government may be OK deferring income taxes on retirement savings, and offering a tax break in some cases when funds are contributed, but they definitely prefer to get to tax that money eventually.  For traditional IRA (and 401k, etc) balances, “required minimum distributions” begin when you turn 70.5. There is a standard calculation that uses the last year ending balance of your funds in all of your traditional retirement accounts and your current age, and kicks out a number that MUST be withdrawn from your accounts and subjected to income taxes.  Failure to meet your RMD comes with stiff penalties on top of the regular taxes.

Because ROTH balances are “after tax” already, they are not typically subject to RMDs.

Why would someone convert to ROTH?
The rationale to convert some or all of your traditional retirement savings to the ROTH style will depend on your particular circumstances.  Some reasons that may be compelling:

• If your income tax rate in the year of conversion is lower than you expect for future years.
  In this case, realizing the income “now” and paying tax at the lower rate may work to your overall advantage
  
  
  
• If you have substantial traditional retirement balances and recognize that eventual RMDs are going to create significant taxable income in the future.
  Strategically converting portions of your traditional balances to ROTH in advance of the RMD years will lower the balances subject to RMD, everything else held equal.
  
  
  
• If your particular estate planning suggests that your eventual heirs and estate would benefit from receiving an inheritance of retirement funds in the ROTH form; as with “regular” distributions from a retirement account during your life, your heirs will owe tax on distributions from traditional IRAs but not from ROTH IRAs.
  If your heirs are themselves in relatively high tax brackets, you having paid the tax in advance (as with ROTH balances) may be to their advantage. 

Some Practical Considerations

• If you do not already have a ROTH IRA established, you will need one.  This step will typically take one business day, and David & DRW Financial can send the appropriate application via Docusign for digital review and signature.
  
  
  
• For traditional IRA balances held at TD Ameritrade and under the management of DRW Financial, and eligible for a partial ROTH conversion, the appropriate form (as of August 2019) is a two page document [TDAI 2424 REV. 11/18] and is available for electronic review and completion via Docusign.
  
  
  

• As shown in this image of Section 3 of that form, you will have the option to convert the “entire” traditional IRA balance, or a portion:
  
  In most cases, you are likely to only be converting a portion, and at an amount we determined through examining the expected tax consequences this year.
  The process and tax implications will be simplified by converting “cash”, as opposed to securities.
  
  
  

• The most immediate and most obvious impact of converting a traditional IRA balance to a ROTH type IRA is that the full amount converted adds to your taxable income for the year.  As laid out in Section 4 of the conversion form, you will have the option to select how much, if any, income tax you would like withheld via the conversion process:
  
  Except in cases where you may have considerable cash on hand to pay your eventual tax liability, or if there are special circumstances where you believe the income generated by the ROTH conversion will be offset elsewhere in your tax work, it will likely be best to have taxes withheld at your expected marginal income tax rate.
  
  
  
• Your age in the year of the conversion matters.  As mentioned above, Required Minimum Distributions begin in the year you turn 70.5, and RMDs must be satisfied prior to converting a traditional IRA balance to the ROTH type.
  You will still be able to convert some or all of the remaining balance after the RMD is withdrawn.
  
  
  
• It is helpful to know your current marginal bracket.  In general terms, income is taxed at progressively higher rates, but only the amount within each bracket is subject to the higher rate.  In some cases, I work with clients to see if “filling up” their current marginal bracket with income in the current year makes sense.

DRW Financial provides financial planning services and investment management to clients
per agreement.  DRW Financial does not provide professional tax or legal advice, and recommends that people engage a tax or legal professional prior to taking action.