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If you’re 60 years old with $1.2 million saved for retirement in a traditional IRA, you may be starting to think about required minimum distributions (RMDs) and the hefty annual tax bill they can create once you turn 73. Converting a portion of your IRA to a Roth IRA each year can help you reduce or avoid RMDs and take control of your tax bill – but also comes at a cost. Discuss your Roth IRA conversion questions with a financial advisor to determine if this strategy aligns with your broader financial plan.
Once you turn 73, the IRS requires that you start taking annual distributions called required minimum distributions (RMDs) from traditional IRAs, 401(k)s and similar tax-deferred accounts. RMDs are calculated by dividing your account balance by your life expectancy factor, a value that is set by the IRS based on your age.
RMD withdrawals are treated as ordinary income. With a large IRA balance, the size of the mandatory RMDs could easily push someone into a higher tax bracket and result in a higher tax bill. Remember, a financial advisor can be a valuable resource when it comes to planning for RMDs.
Roth IRAs, unlike traditional IRAs and 401(k)s, aren’t subject to RMD rules. So by converting your IRA to a Roth, you could avoid having to pay extra income taxes from mandatory IRA withdrawals in retirement. The catch is that you have to pay income taxes on the amount you convert at your ordinary income rate when you convert it. This can lead to a massive tax bill if you were to convert a $1.2 million IRA to a Roth all at once.
Instead, gradually converting your traditional IRA to a Roth IRA allows you to control when you pay taxes. Rather than unspecified mandatory RMD withdrawals, you choose when to take taxable Roth conversions. Roth withdrawals in retirement are then tax-free, provided you wait five years to withdraw those assets.
Keep in mind that the five-year period applies to each conversion. If you were to convert a portion of your IRA in 2024, 2025 and 2026, you’d have to wait until 2029, 2030 and 2031, respectively, to withdraw each group of funds tax-free.
If you need additional help navigating the rules surrounding Roth conversions, use this tool to match with a financial advisor.
Assuming your investments grow at 5% each year for 13 years, your $1.2 million IRA could be worth around $2.3 million by the time you reach age 73. By that time, your first RMD would be approximately $87,000 based on the IRS life expectancy factor. Assuming you’re collecting $80,000 annually in taxable income from pensions and Social Security, adding an extra $87,000 would push you from the 22% bracket into the 24% bracket. (This assumes that the current tax brackets remain in place after 2025 when key provisions of the Tax Cut and Jobs Act sunset.)
