Successful tax planners understand the value of Roth savings. A short-sighted or simplistic approach to Roth conversions could lead to having less after-tax net worth over the long-term.
In this series, we are discussing the often overlooked benefits of Roth conversions.
In our first article, we showed how paying the tax on your Roth conversion is actually one of the benefits.
In this article, we are looking at how reducing your required minimum distributions (RMDs) is another benefit of Roth conversions.
The government allows you to delay paying tax on traditional IRA contributions or retirement deferrals in order to encourage you to save for your retirement. But after a certain age, the government requires you to take some of that money out so they can collect taxes on it. The amount the government mandates you take out of your account each year is called a Required Minimum Distribution (RMD).
Required minimum distributions are taxed as taxable income, the same as other types of traditional IRA withdrawals and Roth conversions.
The start of these distribution requirements depend on your birth year. Currently, most seniors must start RMDs in a specific year between ages 72 and 75.
The amount you must distribute is predetermined based on your age. For example, at age 75, you must distribute one 24.6th share of the account or approximately 4.06%. Every year the divisor gets smaller, the percentage gets larger, and your required minimum distribution is bigger. If investment growth surpasses inflation, your required minimum distribution also grows faster than the tax brackets. This means that growth on your RMD alone can move you into higher taxation, but we will talk more about this effect in a later article.
The RMD amount you distribute from your traditional IRA must be deposited into a regular taxable brokerage account. While taxes related to traditional IRA withdrawals only happen once, the funds in your taxable account are subjected to taxation each year.
Interest, dividends, and realized capital gains in taxable accounts each face the headwind of annual taxation. While qualified dividends and capital gains are taxed at lower qualified rates, ordinary dividends and interest are taxed at your full income tax rate, causing an annual taxable drag of as much as 1.5% to 2% annually.
Often, required minimum distributions are not necessary to support your lifestyle. With strict retirement account contribution limits, many diligent savers have a large taxable account ready to fund their early retirement spending. In these cases, required minimum distributions grow the size of your taxable account, exposing more of your assets to the annual tax drag of the account type.
Whatever you convert to Roth IRA now will reduce your required minimum distributions later. And by reducing your RMDs, you reduce your annual taxation on the growth of those RMDs from the date of distribution onward.
The annual tax drag on a growing percentage of your IRA throughout your senior years can easily surpass a one-time tax on your present day Roth conversion.
None of these tax effects are accounted for with simplistic advice regarding Roth conversions. This method of thinking requires complex, long-term, personalized tax planning.
The value of doing systematic Roth conversions is often much higher than people expect. As part of our tax planning service, we model everything we know about a specific client’s situation, and then approximate doing their taxes in mock every year until they reach age 100. After modeling this baseline, we then try various scenarios and compare the client’s after-tax net worth in each case to their baseline after-tax net worth. Often, it takes several scores of these scenarios to estimate how much the optimum Roth conversion might be worth.
There are many ways Roth conversions produce tax savings. One method of savings is getting to pay the tax on a Roth conversion. Another is protecting more of your IRA assets from the annual taxation of completed RMDs.
Photo by Holly Stratton on Unsplash. Image has been cropped.