Dear Liz: I am a CPA and fairly knowledgeable about investing, but I have a question about my IRAs. I am 58 and my husband is in his mid-80s. We both are retired with federal pensions and no debt other than a mortgage. My plan is to start taking money annually from my traditional IRA in two or three years. I want to reduce the required minimum distribution I will need to start taking at age 701/2 and lessen the tax impact at that time. Should I put these annual withdrawals in my regular investment account or should I put them in the Roth IRA? My goal is to lessen the tax impact on my only child when he ultimately inherits this money. Does my plan make sense?
Answer: Your letter is proof that our tax code is too complex if it can stymie even a CPA. Still, it’s hard to imagine any scenario where you’d be better off accelerating withdrawals from an IRA and putting them in a taxable account.
A required minimum distribution “is merely a requirement to take the money out anyway,” said Certified Financial Planner Michael Kitces, an expert in taxation. “All you’re doing by taking money out early to ‘avoid’ an RMD [required minimum distribution] is voluntarily inflicting an even more severe and earlier RMD on yourself.”
In other words, you’d be giving up future tax-advantaged growth of your money for no good reason.
What might make sense, in some circumstances, is moving the money to a Roth. You can’t make contributions to a Roth if you’re not working, because Roths require contributions be made from “earned income.” What you can do is convert your traditional IRA to a Roth, either all at once or over time. You have to pay taxes on amounts you convert, but then the money can grow tax-free inside the Roth and doesn’t have to be withdrawn again during your lifetime, since Roths don’t have required minimum distributions. Whether you should convert depends on a number of factors, including your current and future tax rates and those of your child.
“In other words, if your tax rate is 25% and your child’s is 15%, just let them inherit the [traditional IRA] account and pay the lower tax burden,” said Kitces, who has blogged about the Roth vs. traditional IRA decision at http://www.kitces.com. “In reverse, though, if the parents’ tax rate is lower … then yes, it’s absolutely better to convert at the parents’ rates than the child’s. In either scenario, the fundamental goal remains the same — get the money out when the tax rate is lowest.”
If you do decide to convert, remember that the conversion itself could put you in a higher tax bracket.
“It will be important not to convert so much that it drives up the tax rate to the point where it defeats the value in the first place,” Kitces said. “Which means the optimal strategy, if it’s to convert anything at all, will be to do partial Roth conversions to fill lower tax brackets but avoid being pushed into the upper ones.”
I see 3 scenarios where it is advantageous to withdraw from an IRA before age 701/2.
(1) To me the implication of the writer’s question is that their retirement income is substantial with 2 pensions and perhaps other income from investments. So there is a good chance that the RMD, the biggest raise some will ever get (4% and more of your assets rather than of a salary!) will push the writer into a higher tax bracket. Good idea to draw down the IRA to reduce the size of the RMD.
(2) If the writer has a taxable estate, the entire value of the IRA will be included as an asset. That means that the deferred taxes, which are a LIABILITY, will be taxed. Best to avoid this double taxation by drawing down the IRA as much as possible if the rest of the estate is large enough to incur an estate tax.
(3)The Bush tax cuts have had a significant effect on the supposed tax advantages of a traditional IRA. Consider the writer’s current IRA. As funds are kept in the IRA any future growth through dividends and capital gains will be taxed at ordinary income rates. Given that the writer has no earned income and cannot contribute to a Roth IRA, any withdrawals would go into a taxable account where the Bush tax cuts give favorable treatment to the growth from both dividends and capital gains. Furthermore if investments are made in solid blue chips for the long term, there will be NO capital gain at death when the basis of an asset is boosted to current market value.
Further comment: when the Bush tax cuts went into effect, it would have been wise to stop contributing to a traditional IRA and put the money into a taxable account. It looks like those tax cuts are going to around for a long time.
Remember that she wants to leave this money to her child. So it likely would be part of her estate regardless, and her estate would have to be worth more than $5 million to incur federal estate taxes. (Also, I think you meant to say that deferred gains would be taxed, rather than deferred taxes.) Converting to a Roth now could make sense if her future RMDs would push her into a higher tax bracket, but it’s hard to imagine a scenario where withdrawing the money earlier to put it in a taxable account would make sense unless we’re talking about a massively higher tax rate in the future.
My scenario 3 is admittedly a special case applying to traditional IRAs funded with post-tax money. Before the advent of the Roth IRA, some of did this with post tax money betting on a lower tax rate in retirement. Of course, now the best place for that post-tax money is a Roth, and though it is better to transfer a post-tax-funded traditional IRA to a taxable account (given the Bush tas cuts), it is probably best to convert it to a Roth. Not sure about those rules.