In Seven Steps to Creating Passive Income through Dividend Investing a couple readers got into a discussion.
It began with this comment:
I’m almost 75 and therefore taking annual RMD’s. One strategy I’m using is to transfer stocks, which are down by the largest percentage, from my regular IRA to my Roth IRA. This should allow them to now grow tax free and also satisfies my RMD for 2020.
There will of course be taxes due on the conversions but the transfers are now worth probably 40% less than a month ago. So I’m betting on only transferring (and paying tax on) $6,000 but later increasing back to $10,000 as the market recovers.
Also, another strategy the author mentioned was buying in pieces to establish a full position. This is an excellent strategy plus with zero commissions it doesn’t cost a fortune in fees.
To which another reader replied:
“and also satisfies my RMD for 2020”
Where did you get the information that a conversion could qualify as an RMD?
See this article.
Or do you still have wage income and are thus taking an RMD and then contributing to a Roth and repurchasing the stocks that are sold in the IRA? if so you can actually contribute $7,000 since you are old enough for catch-up contributions.
To which the original commenter replied:
Vanguard has applied all of these conversions to my 2020 RMD.
And the second reader responded:
I don’t have enough details about exactly what is going on here or exactly how Vanguard is treating this but if we are actually both talking about the same thing then what you describe is not allowed. You can google “can a conversion satisfy rmd” to find multiple articles talking about it.
I would try to get clarification from Vanguard on what they are reporting because a mistake here results in a huge penalty on the order of loss of 50% of the affected funds.
I tucked this conversation away as I wanted to do more research on it.
If you could take RMDs and move them to Roths, that would be awesome!
The planners we’ve seen (especially seminar three and the workshop) seem to think we’re going to take a hammering on future taxes. As such they want everyone to convert to Roths. But the question is always how to do so with the least taxes.
Now if you could take RMDs and move them into Roths (something you wanted to do anyway), that would be a big win-win.
A couple days later I received an email from John Chapman, owner of Chapman Private Client Services. John was the teacher at the retirement workshop we attended.
Here’s what he said:
As the likelihood of higher tax rates increases, many proactive investors are looking to the Roth Conversion as a way to protect their retirement assets. As they do so, one question sometimes arises: Does the amount that you convert to a Roth IRA count towards the Required Minimum Distribution? The short answer is no.
Let me illustrate with an example: Let’s say you want to shift $30,000 from your IRA to your Roth in a given year. Let’s also say that in that same year, you have a Required Minimum Distribution of $20,000. Before you can do any Roth Conversions, you are required to first take your $20,000 RMD. Once received, you can then proceed with your Roth Conversion. Remember, however, that both the conversion and the RMD are taxable events, so be prepared to pay taxes on an additional $50,000 of income. If this is too pricey, you can still do a Roth Conversion, but perhaps at a lower amount.
What typically becomes of the $20,000 RMD, especially if you don’t need it for lifestyle purposes? In many cases, these RMDs get deposited into some sort of taxable account. So, that $20,000 moves from an environment where it only gets taxed once, upon distribution, to an environment where the growth gets taxed each and every year. Doing this only creates more imbalance in your buckets and may lead to increasing your tax liability. So, instead of depositing this into your taxable bucket, contemplate using it to pay taxes on your conversion, fund a Roth IRA, or fund a life insurance program that has long-term care benefits.
For more insight on this topic, read the following Time article.
A few things:
- “Fund a life insurance program that has long-term care benefits.” He’s killing me…
- Do you think he’s reading ESI Money and saw the discussion? 😉
- The link John shared goes to the same article the ESI Money commenter left above.
In the piece John linked to a reader asks:
Can I convert the required minimum distribution from my regular IRA into a new Roth IRA account after paying the income taxes if I am not working? I want to have access to the money in case an emergency comes up.
Here’s a summary of the response:
Sorry, no. According to IRS publication 590-A, the annual required minimum distribution (RMD) from your traditional IRA cannot be converted to a Roth IRA, says Tom Mingone, a financial planner at Capital Management Group of New York.
If you make a mistake and roll over or convert your RMD, it will be treated as an excess contribution, and you’ll pay a penalty of 6% per year for each year it remains in the Roth or traditional IRA. You have until October 15 of the year after the excess contribution to correct it.
What a killjoy the government is. I think they’re on to us. LOL!
Unfortunately, this “great” idea is not so great after all. Since we can’t do it, I’m still left pondering how to address my looming tax bomb (planners’ sentiments, not mine) with so much money tied up in tax-deferred accounts.
But I found an interesting surprise while reading the Money article. It linked to this post which was written by Darrow from Can I Retire Yet. I respect both Darrow and Chris from CIRY so I was interested to see what he had to say.
Some highlights:
Conventional rules of thumb can be inaccurate. You have to run your own numbers and, even then, the accuracy of the answers will be limited by your ability to predict your income far into the future. RMDs and Roth conversions lead to some very complex financial scenarios.
Analyzing my own situation using the best retirement calculators shows only modest levels of RMDs into our 90s, with our current 10% to 15% tax bracket unchanged. In theory, I could generate about 2% to 3% more wealth in the end if I did Roth conversions, as long as I paid the conversion tax from non-IRA assets. If I paid the tax from IRA funds, there would be no value in doing a conversion.
However, that 2% to 3% gain is well within the margin of error for retirement calculations. Who knows if I would ever see it? But, in doing Roth conversions, I would see additional complexity and paperwork in my financial life starting right now. Given that, I’m foregoing Roth conversions for the time being.
Roth conversions are unlikely to save you from high taxation of retirement assets. That’s because the total amount you can convert is limited by the number of years you spend in a lower tax bracket and your “headroom” to the next higher bracket.
I’m not really sure if this made me feel better about the situation or caused more confusion. Haha!
Just joking. I think it has some very valid points, including:
- Your numbers are what matters. Many advisors pitching their “convert to a Roth to avoid a tax bomb” plan are giving out very general advice to a large audience. They do not know you, your finances, your goals, or anything else about you other than you probably have a large amount in tax deferred accounts (which is not much help at all). And yet they are so firm in their recommendations — which they should not be.
- There’s not one clear, “right” path. As with most things money-related, it depends on a number of factors. And if a smart guy like Darrow is having trouble sorting through them to find one, “best” option, most others will be stumped as well (including financial planners).
- Even after a lot of assumptions and calculations, it appears (at least in some situations — and it could be many) that the difference between options is within the margin of error, making both options equal. Who knows, maybe someone in the government worked it out this way. You know, they are on to us! 😉
- No one knows the future, which throws even more doubt into the mix. Is it likely that tax rates will go up? It seems like a reasonable person would say they will. Has anyone ever made a prediction about the financial future that seemed reasonable and yet didn’t work out that way? It’s almost a daily occurrence.
In the end, I don’t know what the right answer is for us. I’m still working that out.
But thanks to a conversation in the comments here and a timely email, I know I can’t move my RMDs straight into a Roth.
Dang. That would have been so sweet…
That is too bad about the IRS negating RMD to Roth conversions.
One advantage I think for those who FIRE is that there is a longer window to covert into ROTH so hopefully can transfer the majority of the tax deferred money into Roth before RMD even hits.
Ideally could have 2-3 yr bucket of cash to live on and no income to do the conversions necessary. For me my situation is complicated because I have built up so much passive income from real estate syndications etc that I might not have much headroom to keep me under the 25% tax bracket which I heard was the top you would really want to covert money in.
Hi Xrayvsn, another complexity might be burning through the cash bucket removes a buffer on sequence of returns risk. Then, there’s the concern about managing future years income limits to keep health insurance costs doable (ACA-style); example: cash bucket is empty but need to sell assets to refill and cover current living expenses => could turn into a high income year in the future.
Great article. I like the discussion method.
In John Chapman’s quote the second to last sentence reads, “So, instead of depositing this into your taxable bucket, contemplate using it to pay taxes on your conversion, fund a Roth IRA, or fund a life insurance program that has long-term care benefits.”
Is he saying that someone could take an RMD of say $30,000, put it into a regular brokerage account, and use part of that money to fund a Roth IRA. From the above comments, the maximum allowable annual contribution for an IRA can be about $7000. This would at least shield part of the RMD from taxes and be legal.
I think that the idea is that $30,000 could be used to pay the additional taxes necessary to convert another $100,000 from a tax deferred IRA (and 401(k) balances can be rolled into IRA after retirement) into a Roth IRA. Given social security income and $30,000 RMD, taxes on that $100,000 conversion might only be in the $12,000 to $24,000 range, which would be handled by the $30k RMD.
I’ve spent a lot of time trying to figure out the best strategy for ROTH/IRA tax minimization. My wife and I have the added wrinkle of both being under age 65, so in need of healthcare coverage outside of Medicare.
While being on the younger side is a big advantage in terms of doing a ROTH conversion because it has more time to “win back” the taxes paid, the downside is that it counts toward income which can drive up the cost of healthcare insurance premiums obtained through the ACA (in California it’s Covered California).
To get a better handle on all these connected pieces I used a pretty sophisticated spreadsheet model that is offered for free by the Bogleheads. It is aimed specifically at helping you evaluate the effect of ROTH conversions, as well as optimal timing for claiming Social Security. Check it out here: https://www.bogleheads.org/wiki/Retiree_Portfolio_Model
My theory is draw from IRA money first when we are in a low bracket, thus reducing the value of the IRA and less to have as an RMD. To me, converting is still worth doing at a low rate vs tax rates in the future, but we always assume higher, but people are paying lower than they were 10 years ago in a certain bracket.
Since converting RMD to Roth IRA is out, keep in mind you can move up to $100K per year of your RMD to a charity tax free. I think this was covered by ESI before or from another site. So, if you have to take out $30K for RMD, send it directly from IRA to the charity, and you will not be taxed on it. Seems like it will solve a lot of tax problems and it helps the charity. We are keeping this in mind when we hit 72 in about 20 years.
https://www.investopedia.com/taxes/can-i-use-money-my-ira-donate-charity/
https://www.fidelity.com/learning-center/personal-finance/retirement/qcds-the-basics
excellent thought piece. i have always said where you put your assets early on can mean as much as what assets you’re buying. those allocations are important for us and we’re aiming to get as much money into roths as early as possible even if that means paying slightly higher taxes in the present. for instance, for my money i would consider trying to place what i think could be higher flying growth stocks in roths and weight the “safer” stuff like fixed income or steady/boring dividend stocks in a traditional ira/401k. i wish i had thought of that before i owned so much shopify in a traditional ira! oops. tax free might have been nice on that one.
That’s a great plan, especially if you believe tax rates are going up, across the board, in the future. Seems like the consensus of most of smart people here is that all tax rates will rise. That makes paying the tax now more palatable. It also helped me to convince my wife (who’s older than me) to start taking social security now, rather than waiting till 70.5. Higher future taxes plus the specter of means testing social security benefits was the double whammy that put us over the edge!
These are great conversations – thanks for contributing!
“Is it likely that tax rates will go up? It seems like a reasonable person would say they will. Has anyone ever made a prediction about the financial future that seemed reasonable and yet didn’t work out that way? It’s almost a daily occurrence.”
I’ve been hearing tax rates will go up 30+ years since the era of Cold War deficits.
Don’t believe the hype.
Further, if taxes go up, they are (hopefully, wisely) going to be targeted at the top 1% or top 0.1% — wealth taxes, estate taxes, eliminating tax deductability for mortgage interest on second homes, progressive capital gains taxes, eliminating the cap on Social Security taxes (which currently means you stop paying them after you hit $132k in income in a year), more progressive and thus fair state income taxes, etc. If you’re in that group — congrats, you’ve already succeeded to a degree unimaginable in most of human history, so don’t sweat it.
Remember, there are no RMDs in 2020.
They skipped RMDs in 2009. Probably not a huge impact for most.
It is always interesting to see the many discussions that go on about Roth , 401K’s and RMD and when to take Social Security. These discussions seems to dominate a lot of discussion in the US Blogs I read. I am just pleased given the many things to be considered that its not something that has to be on my radar as it seems there are many things pitfalls to be avoided when making decisions.
Superannuation Funds in New Zealand(whether private or Kiwisaver) have their profits taxed each year so when it is paid out (Kiwisaver is available when you turn 65 though it is not mandatory to withdraw at that age) it is tax free. Downside to that of course is most people pay a higher tax rate whilst they are working than when they reach retirement but it does remove a lot of complexity which for a lot of people is probably a plus. 65 is the age that NZ Superannuation (our version of social security kicks in) In NZ the amount of NZ Superannuation is the same regardless of how much you earned during your working life
I have no opinion as to if one country’s way is better or worse than the other. We each simply have to live with the system our Country has for better or worse and make decisions appropriate to our individual circumstances within the “rules” each of our respective governments set.
Chapman says, above, “Before you can do any Roth Conversions, you are required to first take your $N RMD. Once received, you can then proceed with your Roth Conversion.”
How literally do I interpret “before”? If both RMD and Roth Conversions are done in the same year, does it depend which order it was done? I would like to postpone taking the last of the RMD until December, when we get so many charitable donation requests. But I also want to do some Roth conversions during the year when there are dips in the market.
I would assume it means if your RMD is $20K, you have to withdraw $20K and anything after that would be eligible.
Yes, I got that. My question is: Can I do a Roth conversion in Jan 2021 and then my full RMD withdrawal in Feb 2021? How literally is “before”? It sounds like the order of withdrawal, but I’m coming to believe that it is OK as long as it all happens in the same year.
Can I reword your answer from “anything after that” to “anything more than that” or “anything beyond that”?