A client of mine (we’ll call him “Tom Taxable”) recently asked me if he should consider converting his traditional IRA to a Roth IRA. This question recently reared its head around tax time when Tom was shocked by the amount of tax he had to pay on his “required minimum distribution” or “RMD” courtesy of the IRS. You see…Tom turned 70 1/2 last year which required a ~3.8% withdrawal from all of his IRA accounts.
To make matters even worse, Tom’s RMD increases with age each year per the following table:
Basically, Uncle Sam is telling Tom the following:
“Hey Tom…remember during the last 40 yrs when you were salting away all that money in your IRA without paying any taxes? Well…now that you are retired, Uncle Sam is reminding you that I am “part owner” of your IRA and want to collect my share of your “tax time bomb”. Now, that’s only fair…right? So…”Uncle Up”.
After I explained the above to Tom, he couldn’t believe that his $1,000,000 IRA might be worth only $650,000 after taxes! And what if taxes increase in the future…there goes Tom’s retirement dreams! Needless to say, Tom was “all ears” when I told him that there are strategies for converting his traditional IRA to a Roth IRA that could significantly reduce his tax burden going forward.
What Are the Advantages of a Roth IRA Conversion?
There are many advantages of a Roth IRA vs a traditional IRA, such as:
- No required minimum distributions (RMD’s)
- Tax free growth
- Tax free withdrawals (subject to certain rules)
- Tax free legacy for beneficiaries
In fact, a Roth IRA is considered by most financial experts to be the “Holy Grail” of investments because of the above reasons.
Am I Too Old for a Roth IRA Conversion?
First of all, Tom thought that he was too old to fund a Roth IRA. Well, we are not talking about “funding” a Roth IRA from scratch. Rather, we are taking about “converting” a traditional IRA to a Roth IRA via a “Roth IRA Conversion”. There are no age or dollar limits on a Roth IRA conversion. Therefore, I told Tom that he can convert any traditional IRA to a Roth IRA either all at once or over a period of years to spread out the taxes.
Ok…but Don’t I Have to Pay Taxes?
Yep! The main “catch” in converting a traditional IRA to a Roth IRA is that Tom would have to pay taxes on the amount converted. In other words, the IRS is not offering him a “free lunch” anymore. Those days are over! However, Tom would like to “hedge” the risk of higher taxes in the future plus leave a “tax free” legacy to his children and grandchildren who will probably pay higher taxes 20-30 years from now. All excited about saving taxes, Tom asked me to educate him on the various strategies for converting his traditional IRA to a Roth IRA.
How About a “No Brainer” Roth IRA Strategy?
My #1 “No Brainer” strategy for executing a Roth IRA conversion applies to everyone who MUST take their RMD’s each year. This means EVERYONE who is over age 70 1/2 and has an IRA account. The larger the IRA account, the larger the benefit.
Here’s a simple process for converting to a Roth IRA:
- Open a Roth IRA account at your local bank or custodian
- Transfer your annual RMD in a “LUMP SUM” from your IRA to your new Roth IRA account. (Hint: DO NOT send the RMD check to yourself or you will complicate the process by requiring a “messy” 60 day rollover)
- Invest the Roth IRA conservatively so you can grow the account before paying taxes the following year (Hint: Convert early each year, e.g., in January, to maximize “tax free” earnings growth before taxes are due)
- Withdraw funds, tax-free, as needed, for lifestyle, taxes, etc
- If possible, pay the taxes due on the conversion from funds outside the new Roth IRA to maximize the value of your Roth IRA
Please note that the order of funds withdrawn from a Roth IRA follow “FIFO” accounting which stands for “First In First Out”. This means that the money that you converted to the Roth IRA comes out first…”tax free”. Any gains in the Roth IRA must be held for 5 yrs before they can be withdrawn “tax free”. This is usually not a problem because the amount converted will far exceed the interest earned in a given year.
This strategy is especially attractive for folks who don’t need 100% of their RMD for living expenses and/or wish to leave a “tax free” legacy to their beneficiaries. However, it will also work for those who want to spend most of their RMD while earning tax free interest, dividends, etc, going forward.
How to Reduce Taxes on the Roth IRA Conversion
Another unique strategy involves the use of a bonus annuity to convert an IRA to a Roth IRA. This strategy utilizes the annuity bonus to pay up to 60% of the conversion tax depending on the individual’s tax bracket. If desired, some of the funds in the annuity can then be moved into another Roth IRA invested in stocks, bonds, etc. The end result is two (2) Roth IRA’s…one safely invested in a fixed indexed annuity and another invested in the stock market.
Here’s Another RMD “Tax Free” Legacy Strategy
Another strategy is ideal for folks who want to spend most of their RMD each year but would like to leave a “tax free” legacy to their heirs. This strategy entails using a portion of their annual RMD to purchase life insurance to convert all or most of their “IRA tax time bomb” into a tax free legacy. In this case, someone in the household must be insurable and under the age of 85. As a side benefit, this strategy also provides long term care coverage which can help mitigate one of the biggest risks faced by retirees.
What is Your Next Step?
You really owe it to yourself to explore these strategies to see if they are right for you. Tom did…and he is happy that he is saving on future taxes for himself and his heirs. If interested, give me a call so I can show you how many of our clients have reduced their future tax liability using one of our RMD and Roth IRA conversion strategies. Also, we will work with your tax professional to make sure that he/she approves our recommendations.
Until next time…relax, give thanks, create happy memories and let us navigate your ride down Wall Street!