Written by attorney Leon Labrecque

Using an Unwanted RMD to Fund a Roth IRA

November 8, 2010. It's clear from many commentators (present company included) that Roth IRAs and more specifically Roth conversions are an important wealth planning consideration. The Roth IRA has two primary tax efficient qualities: qualifying distributions are free from income taxes; and Roth IRAs are NOT subject to Required Minimum Distributions (the mandatory distribution from a traditional IRA that must begin at age 70 1/2 ). You can convert a traditional IRA to a Roth IRA by paying the taxes on the conversion (and even splitting the income from the conversion into 2011 and 2012) and thereby eliminate/reduce your future RMDs and eliminate income taxes on all the future growth and income. Roth conversions create many planning opportunities, which are covered in our White Paper on Roth IRAs (click here for a copy). Roth conversions provide tax-free income to heirs, avoid future higher tax brackets for the owner and their surviving spouse, and potentially reduce estate taxes (we're assuming eventually the folks in D.C. will make a decision). One pre-eminent group that should consider conversion are IRA owners over age 70 1/2 who don't need or want IRA minimum distributions to supplement their income. Starting at age 70 1/2 (actually April 1st of the year after you turn 70 1/2 for some perplexing reason), an IRA owner must begin taking Required Minimum Distributions ('RMDs'). By virtue of the mathematical calculation (the denominator is based on life expectancy, which obviously gets shorter as you get older) used to compute RMDs, most IRA holders will eventually take larger and larger distributions until they creep into a higher tax bracket. In addition, the death of a spouse puts the survivor in a potentially higher bracket because the filing status changes. Plus, many retirees don't need or want the RMD: they don't need the money to supplement their income, it just causes an increase in their tax bills. Enter an interesting strategy, introduced to me by one of our senior partners, Brian Roehl. Our firm has a lot of clients over age 70 1/2 . In 2009, the Required Minimum Distribution rules were suspended for one year: for '09, you didn't have to take an RMD. In 2010, you do. In 2009, we took advantage of the lower tax brackets for many clients by making Roth conversions. Now for 2010, those same folks are taking unwanted taxable RMDs. Brian's idea was simple: why not use the RMD to pay the tax on a Roth conversion? The law states that you must take a Required Minimum Distribution before you do a Roth conversion (you can't convert an RMD), but nothing says you can't use the RMD to pay the tax. Here's how it would work: John and Marilyn are both 73. They have $52,109 of pension income, other taxable income of $38,000, and Social Security of $40,895. They have IRAs worth $585,000 and don't need or want the RMDs. They have kids they like, ages 45 and 42. Let's assume they make 7 1/2 % on their investments and inflation is 3% (for tax brackets). For purposes of this illustration, we'll assume they are Michigan residents. Scenario One: Don't convert anything. Under this one, they take their RMD. The RMD percentage is less than the rate of return until age 87, so for that period, the IRA grows. After 87 the RMD starts dissolving principal. At age 95, the IRA is worth about $617,000. By age 95, they would have taken $1.1M of RMDs and paid about $323K of taxes. If they die at 95, the kids inherit the IRA and pay income taxes on the $617K, plus earnings, over their distribution period. Scenario Two: Use the RMD to convert to a Roth. Under this scenario, they take the RMD and use the entire RMD to pay taxes on both the RMD and whatever Roth conversion they can do. For example, in 2010, their RMD would be $23,684. The taxes on the RMD itself would be about $6,951, leaving $16,733 net. In their bracket, they could use that $16,733 to convert about $60,074 into a Roth. For 2011, their IRA is now $543,340, so the RMD is smaller, not larger. On the projected 2011 RMD of 22,829, they have to pay $6,700 of taxes, net $16,129, and convert $57,120. Same game for 2012, and so on. By age 95, they have depleted the conventional IRA down to $5,895. Their total RMDs were only $222K. The total tax on RMDs would have been about $65K, but they would have paid $157K of taxes on the Roth conversions. But here's the kicker: at age 95, their Roth IRA would be worth just about $2Million! That's tax-free to the kids as well. Less taxes, more money. No RothConvert Net RMDDifference Starting IRA585,000585,0000 Total RMDs1,102,750221,906-880,844 Ending Trad IRA @ 95616,7015,895610,806 Saved RMD after-tax 1,301,07201,301,072 Tax on IRA to kids181,0021,474-152,701 Net435,7004,421462,526 Roth0 1,998,7811,998,781 Total Wealth1,736,7722,003,202266,430 Looking at the chart, and comparing apples to apples, we'll presume the IRA owner takes their entire net RMD and invests it exactly the same as they would their IRA (even though evidence is that investors tend to put their RMDs in safer investments at lower returns, or give it to their kids). We'll presume the kids are in the same brackets as their parents. The use of the RMD to pay the taxes on the Roth conversion is worth about $266,430 to the family in this example. Optimization: Is this the best way to do Roth conversions? In my opinion, not necessarily. I feel that you can 'optimize' a conversion to utilize tax brackets. But this one is simple, works, and if the retiree doesn't like their RMD's, they get rid of them. Mechanics: An easy way to make this work is to withhold 100% for taxes on the RMD, avoiding worry about annualizing and estimated payments. Because we're making serial conversions, we wouldn't split this kind of conversion for 2011 and 2012. In addition, you have to do the conversion after the RMD, so do the RMD and withholding, and then do the conversion. Of course, you can then do all of the other wonderful things we talk about in our Roth paper, like segregating IRAs and so on. Roth conversions are a great wealth management tool. In this case, you can use unwanted RMDs to fund the taxes on the Roth. And, nothing says you have to do this forever, you could convert for a while and then keep the RMD at a reasonable level. Flexible, saves taxes, and makes money. "I am proud to be paying taxes in the United States. The only thing is I could be just as proud for half of the money." -- Arthur Godfrey Stay tuned, Leon

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