Using Roth Conversions to Reduce Future RMDs

Large pretax retirement accounts can create a tax challenge later in retirement.

Required minimum distributions, or RMDs, are annual withdrawals the IRS generally requires from traditional IRAs and other pretax retirement accounts once you reach the applicable RMD age. The amount is calculated by dividing the prior year end account balance of your IRA balance by an IRS life expectancy factor.  As you age, the IRA balance may increase with market returns while the life expectancy factor decreases with time.  

The IRS goal is to force distributions to create taxable income and generate federal tax revenue.  RMDs force money out of these accounts whether the retiree needs the income or not. Those distributions are generally taxable and can affect far more than the annual income tax bill.

Roth conversions can potentially reduce the amount of pretax assets that will eventually be subject to RMDs, giving retirees more control over future taxable income.

Consider a retiree in his mid sixties with $3 million in traditional retirement accounts.  He has sufficient taxable savings to cover his lifestyle and does not currently need withdrawals from the IRA.

If the IRA continues to grow for many years before required minimum distributions begin, the account could become significantly larger.  When RMDs eventually start, the retiree may be required to recognize substantial taxable income each year, even if he does not need the money.

Those distributions will likely affect his marginal tax rate, Medicare premiums, and the taxation of other income.

Instead of waiting, he could evaluate a series of partial Roth conversions before RMDs begin.  Each conversion reduces the amount remaining in the traditional IRA and moves assets into a Roth IRA. Over time, this may reduce future required distributions while increasing the portion of retirement assets available in a Roth account.

The analysis is not simply about reducing an RMD.  An IRA conversion creates taxable income today, so the important question is whether paying those taxes voluntarily now is preferable to potentially paying taxes on larger forced distributions later.

Future RMDs should be considered alongside Social Security, pensions, investment income, capital gains, Medicare IRMAA and other sources of retirement income.

For someone with a substantial pretax retirement balance, waiting until RMDs begin may mean giving up years of planning flexibility and potentially paying more tax over time than necessary. Thoughtful planning before RMDs begin can help manage future taxable income and create opportunities to use lower tax brackets more efficiently.

We model projected retirement account growth, future distributions and potential Roth conversions to evaluate whether reducing pretax balances today may improve your long term financial picture.