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Retirees with significant assets often have to plan around required minimum distributions (RMDs).
If you already have sufficient income and don’t need the money in a pre-tax portfolio, annual RMDs can cost you significantly in taxes that would otherwise be unnecessary. For example, let’s say you have $1 million in a 401(k). The IRS could require you to withdraw tens of thousands of dollars from this account each year, taxing it all. For households that don’t yet need that money, this can lead to an unnecessarily high tax bill.
A financial advisor can help you plan for RMDs and make other important retirement decisions.Find a fiduciary advisor today.
Moving your money into a Roth IRA can help you save on those taxes in retirement, since this money has already been taxed and is not subject to RMDs. However, making that transfer will significantly increase your taxes up front, so it’s important to make sure this doesn’t cost you more money in the long run.
Required Minimum Distributions (RMDs)
Required minimum distributions, or RMDs, are a feature of pre-tax retirement accounts, such as 401(k)s and traditional IRAs.
Starting at age 73, people with a pre-tax retirement account should begin withdrawing a minimum amount each year. This rule applies per account. For example, if a person owns both a 401(k) and an IRA, they will need to make a minimum withdrawal from both accounts each year. The RMD amount each year depends on the value of the individual account and the age of the account holder.
RMDs are designed to trigger a tax event. As with all pre-tax withdrawals from a portfolio, RMDs are taxed as ordinary income. The IRS wants people to eventually pay taxes on the income saved in these portfolios, so it requires that you make at least some withdrawals during retirement. For this reason, RMDs do not apply to Roth IRAs and Roth 401(k).
RMDs can significantly increase a household’s taxes. For example, let’s say you’re 80 years old and have a $500,000 IRA that you don’t currently need to support your lifestyle and expenses. However, the IRS will require you to withdraw $24,752 from this account, all of which will count toward your taxable income for the year. Not only will you have to pay taxes on this money, but you will have to choose between selling the assets (and sacrificing future growth) or raising the tax money from another source. Keep in mind that a financial advisor can help you calculate how RMDs will affect your tax situation and how best to handle them.
A 62-year-old man approaching retirement smiles as he thinks about his future.
Roth IRAs are not subject to RMD rules, so converting a pre-tax account to a Roth portfolio is generally the easiest way to avoid minimum distributions.
For example, let’s say you’re 62 years old and have a $1 million 401(k) plan. Without taking into account contributions and withdrawals, at an 8% growth rate, this portfolio could be worth $2.33 million at age 73. The IRS would require you to withdraw $87,924 from that account that year, which would put a person near the top of the 22% tax bracket even before accounting for any income from Social Security and other retirement portfolios.
On the other hand, if you kept this money in a Roth portfolio, you could leave it there until you needed it. It could be saved for later in life and continue to grow without withdrawals or taxes.
The main problem with a Roth conversion is that, in exchange for saving on taxes later, you must pay income taxes now. Any money you convert to a Roth IRA must be included in that year’s taxable income. So, for example, let’s say you earned $100,000 in 2024 and converted $1 million from your 401(k) to a Roth IRA in the same year. Your taxable income for 2024 would be $1.1 million, which is equivalent to almost $360,000 in federal income taxes, assuming you take the standard deduction.
To manage this you can do what is called a staggered or gradual conversion. Instead of revamping your entire portfolio, you can transition one part at a time. This allows you to ensure that you never run up a tax bill larger than you can handle each year and that you don’t jump into a higher tax bracket. If you are over 59½, you can also withdraw a portion of your account to raise money for those taxes. This, of course, would reduce your retirement savings.
For example, let’s say you earn $100,000 per year and have $1 million in your 401(k) at age 62. If you convert $100,000 per year, you would increase your taxable income to $200,000 per year and pay approximately $38,000 in federal income taxes. At age 73, you’d probably still have a sizable amount in your 401(k), since account growth would partially offset your conversions, but you’d have the million dollars in an account free of taxes and RMD requirements. But if you need more help estimating your tax liability and the impact of RMDs, consider speaking with a financial advisor.
Just be careful with two issues.
First, Roth contributions cannot be withdrawn for five years after they are made. This five-year rule applies separately to each conversion. So if you do a series of staggered conversions (one per year), you’ll have to wait five years after your first conversion to withdraw that money, another five years to withdraw the money from your second conversion, and so on. Violation of this rule will result in taxes and a 10% fine.
Second, these taxes will accumulate. Each year, you will pay income taxes on the money you convert to your Roth IRA. Depending on your tax bracket when you make these conversions, your initial taxes could well be higher than the income taxes you would pay on minimum distributions in retirement. Consider talking to a financial advisor to make sure you’ll really benefit in the long run, because if you’re not careful, this strategy can cost more than you’ll save.
Stepping conversions from a 401(k) to a Roth IRA can reduce or eliminate the need for required minimum distributions (RMDs) while saving you money on your tax bill each year. However, if you’re close to retirement, make sure your initial taxes don’t cost you more than distribution taxes would cost you in retirement.
The IRS only requires that you take required minimum distributions at the end of each year. When and how you make these withdrawals is up to you, so be sure to structure these distributions for your maximum benefit.
A financial advisor can help you create a comprehensive retirement plan that takes into account your RMDs and their tax impact. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three vetted financial advisors serving your area, and you can take a free introductory call with your matched advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Keep an emergency fund on hand in case you have unexpected expenses. An emergency fund should be liquid, in an account that is not at risk of significant fluctuations like the stock market. The downside is that inflation can erode the value of liquid cash. But a high-interest account allows you to earn compound interest. Compare savings accounts at these banks.
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The post I am 62 years old and have $1 million in a 401(k) plan. Should I convert $100,000 per year to a Roth IRA to avoid RMDs? appeared first on SmartReads by SmartAsset.
