Q & A: Required Minimum Distributions & Roth Conversions

Welcome to the Q & A series where I answer your finance questions. If you have a question or a topic you'd like me to write more about, contact me.

Question:

We are worried that we are contributing “too much” to pre-tax accounts and will end up paying a lot in taxes during retirement. Should we invest in a taxable account and forgo some of the tax benefits now to diversify our portfolio?

Answer:

I see some form of this question a lot. Your concern about “too much” in pre-tax accounts is valid for two main reasons – taxes and required minimum distributions (RMDs). Let's talk about taxes first with regard to pre-tax retirement accounts like the 401(k), 403(b), or pre-tax/rollover IRA. You get a tax break when you contribute to it and will owe income taxes on the amount you withdraw. So, if you contribute “too much” into these pre-tax accounts, you'll end up paying a decent amount of income taxes on withdrawal if you don't have as much money in after-tax accounts. One great way to get around this is by doing Roth Conversions. Roth Conversions refers to moving pre-tax retirement accounts into a Roth IRA. (Note: you cannot do this with an inherited IRA. Also, Roth Conversions are not the same thing as the backdoor Roth IRA conversion – confusing I know.) You'll pay taxes at your current marginal tax rate on conversion. The key is to time these conversions in low income years such as the year you stop working. Assuming you “retire” before age 70.5, the general strategy is to convert an amount each year to fill up a lower tax bracket vs. the likely much higher tax bracket you are in during your wealth accumulation years. Another important point about Roth Conversions is purchasing power. If you think about the total amount in your different accounts – pre-tax, Roth IRAs, and taxable accounts, they have different amounts of purchasing power. Basically, assuming 25% marginal tax rate for illustration purposes, if you have $100K in a pre-tax IRA and $100K in a Roth IRA – the Roth IRA actually has “more money” or more purchasing power since it won't be taxed. That $100K in the pre-tax IRA will be $75K if you withdrew the full amount, not $100K. The second part of the answer has to do with RMDs. Except for Roth IRAs, retirement accounts are subject to RMDS starting at age 70.5. This means that starting at age 70.5 you will be required to take out a minimum amount from your non-Roth IRA retirement accounts. The amount is determined by your projected distribution period and the balance of the accounts subject to RMDs on 12/31 of the previous year. The projected distribution period is based on an actuarial calculation from the IRS based only on your age. So, your medical and family medical history have no bearing. Curiously, if the sole beneficiary of these accounts is a spouse that is 10 years or more younger than you, than the distribution period will be extended, thus lowering your RMDs. One notable exception to the age 70.5 RMD rule is for 403(b)s funded before Jan 1,1987 – the RMDs for these amounts start at age 75. There is a huge penalty for not taking out your RMD – 50% of the amount you should have taken out + income taxes! The IRS made an exception to this harsh penalty in 2009 due to the down market. Having money in a taxable account is valuable due to the flexibility of being able to access it before age 59.5. There are ways to access your retirement accounts before then if you really want to, however. These topics are covered well in the following books: