The taxman cometh.
All that money feathering your IRA nest isn’t tax free — just tax-deferred. Uncle Sam wants his cut. Once you turn 70 1/2, you must start withdrawing it at a rate determined by the government and pay tax on it. This is the required minimum distribution (RMD).
You can use the RMD to fund Roth contributions, but only up to the annual limit, currently $6,000.* I wondered whether it would make sense to accelerate the withdrawals by converting the IRA into a Roth.
As is usually the case, this turned out to be a more complicated question than I expected. I built a spreadsheet with lookup tables for tax rates and the RMD schedules. I created three accounts: an IRA, a Roth, and a taxable portfolio. RMD’s from the IRA end up in the taxable portfolio, after paying taxes.
For every scenario I tried, it did not make sense to accelerate distributions. A typical result is shown below. (Click on the graph to enlarge.)
In the above graph, the purple triangles are the total value of the three investment account (IRA, Roth and taxable portfolio) for the case of no Roth conversion. The large red triangles are the total value of the accounts if 10% of the IRA is converted each year (in addition to taking RMD’s). The small blue, pink and yellow symbols are the value of each account for the “with conversion” scenario.
As can be seen in the graph, the person would have to live to 102 to break even with the tax paid up front. While I hope to reach 102, I don’t base my retirement planning on it.
The inputs to the scenario (and the values used for the above graph) are:
- Initial age (72)
- Beginning value of IRA ($500,000)
- Beginning value of Roth ($100,000)
- Beginning value of taxable portfolio ($200,000)
- Other income ($40,000)
- Investment return (2%, after inflation)
- Annual expenses ($40,000)
If you’d like the full spreadsheet, email me, and I’ll send you a copy.
For morei nformation on required minimum distributions, please see IRS Publication 590: IRA’s.
*To make a Roth contribution, you must have earned income and meet income limits.
Disclaimer: The information in this post is for educational purposes only. There are other assumptions in this scenario, including, for example, that the person is married and that the beneficiary is his spouse who is less than ten years younger. Your situation may well be different. Before taking action, please see a financial professional for your specific situation.
Carnivals: This post was included in the 238th edition of the Carnival of Personal Finance, hosted this week at The Financial Blogger.
Science and Money Feed
Jim Blankenship, CFP®, EA
on Jan 3rd, 2010
@ 12:11 pm:
Helen -
This is a very good factual review of the impact of Roth conversion over time…
One factor that you didn’t take into account in your otherwise excellent review of the impact of Roth conversion is the increase over time of tax rates. For each amount A that you convert to Roth at tax rate T, you no longer have to pay tax on that amount and it’s growth (amount A times growth rate G raised to the power of years Y are not taxed at the increased tax rate T+?+?+?). Of course if tax rates remain the same or reduce, this benefit is lessened – but my money’s on increasing tax rates over time.
In addition, if the taxpayer doesn’t have the need to use the RMDs from the Trad IRA to pay current living expenses, by converting at today’s presumably lower rate of taxes, she’ll never be required to take those distributions out in later years. Of course her heir(s) would be required to take them over the course(s) of the heir(s) lifetime(s), but the distributions would continue to be tax-free at that point.
Thanks for the review – it’s always helpful to see the impacts of decisions made today played out over time, which is what we do!
jb
The Carnival of Personal Finance #238 – 5 Tricks To Keep Your Resolutions For The Year Edition | Finance Blog
on Jan 6th, 2010
@ 7:19 am:
[...] Helen from Science and Money presents Required Minimum Distributions vs. Roth, and says, “The taxman cometh when you turn 70 1/2, and he taketh away the taxes on your IRA [...]
Helen
on Jan 6th, 2010
@ 10:43 pm:
Jim:
Good point about the possibility of an increase in tax rates. After all, someone’s going to have to pay the bill for all the bailouts of the last few years (banks, automakers…). I agree that it’s important to hedge against future tax increases by dividing retirement funds between pre-tax and post-tax investment vehicles.
Thanks for your input — always appreciated.
The Financial Blogger » Blog Archive » The Carnival of Personal Finance #238 – 5 Tricks To Keep Your Resolutions For The Year Edition
on Jan 10th, 2010
@ 6:22 pm:
[...] Helen from Science and Money presents Required Minimum Distributions vs. Roth, and says, “The taxman cometh when you turn 70 1/2, and he taketh away the taxes on your IRA [...]