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Ask An Advisor: Can I Harness the Bear Market to Cut My RMDs and Tax Bill?
Brandon Renfro, CFP®
Sun, January 8, 2023 at 8:00 AM CST
I am currently in a 12% tax bracket and attempting to convert as much money as I can to a Roth individual retirement account (IRA) without going into the next bracket. I am trying to do this to reduce my required minimum distributions (RMDs) when I reach 72. In doing so, I am also paying my taxes from outside my retirement accounts. Is it a good idea to make the conversion when the market is down? Can I wait until Tax Day to pay taxes on that conversion? I am anticipating increasing tax rates after the Republican tax cuts sunset in 2025.
The Roth conversion strategy you’ve described is a great way to get in front of required minimum distributions (RMDs) and potentially reduce the total amount of taxes that you’ll pay over time as well. Here are my thoughts on executing that strategy and preparing for your tax bill.
A financial advisor may help you understand the tax impacts of your investment and income decisions.
Understanding Required Minimum Distributions (RMDs)
Tax-advantaged retirement accounts like 401(k)s, 403(b)s and IRAs require that you take required minimum distributions once you turn 72. Under prior law, the age to begin taking RMDs was 70 ½, but it was raised to 72 with the passage of the Setting Every Community Up for Retirement Enhancement, or SECURE, Act in 2019.
The amount you have to take is based on your remaining life expectancy according to IRS tables. You can wait until April 1 of the year after you turn 72 to take your first RMD, but you need to do it by Dec. 31 each year after.
The distribution gets no special tax treatment. When you withdraw from tax-deferred accounts, you must pay taxes at your tax rate.
A potential problem here is that it limits your flexibility, reducing your ability to plan your distributions in the most tax-efficient way.
Roth Conversions to Avoid RMDs and Future Taxes
So with that understanding in mind, how does a Roth conversion help?
The RMD rules do not apply to Roth IRAs, and qualified distributions aren’t taxable. To alleviate both the requirement to take RMDs and tax implications of future withdrawals, you can move money from your tax-deferred account into a Roth IRA.
Roth Conversions When the Market Is Down
Whether a conversion is a good idea for you is dependent on a number of factors. The big things to consider are your ability to pay the taxes and your current and expected future tax rates. The general idea is that if you are in a lower tax bracket now than you expect to be in retirement, and you can afford the tax bill, a Roth conversion usually makes sense.
If a Roth conversion is good for you, a down market makes it even better. That’s because your tax bill is based on the amount you convert. If the market has dropped, you can move more shares for the same dollar amount (and tax bill).
Here’s a simple example: Suppose you have 1,000 shares of an exchange-traded fund (ETF) in your tax-deferred account that you want to convert. At the start of the year, each share was worth $65, so in total, it was worth $65,000. If you convert all 1,000 shares, you’d owe taxes on $65,000.
But now, suppose that the price of those shares has dropped to $50 and they are worth a total of $50,000. You can convert the same 1,000 shares and pay taxes on $15,000 less.
At a 12% tax rate, that makes the conversion $1,800 cheaper.
Paying the Tax Bill
It’s good that you are able to pay the taxes from outside your retirement account. As for whether you can wait until you file your return next year to actually pay the tax bill, it depends.
There’s no special rule for conversions. You simply need to follow the standard IRS tax payment rules. Those rules essentially require you to pay taxes throughout the year, so that by the end of the year, you have paid an amount roughly equal to your expected tax liability. Refunds or payments at filing time are simply the difference between your prepayments and actual tax liability.
Most employees don’t have to worry about this because their employer withholds estimated taxes from their salary and sends a check to the IRS for them. Contractors and self-employed individuals estimate taxes quarterly and send in the appropriate payment themselves.
To avoid an underpayment penalty, you need to make estimated tax payments equal to:
- At least 90% of your total tax liability for the year. Or …
- At least 100% of last year’s tax liability if your adjusted gross income (AGI) was under $75,000 if you are single and $150,000 if you are married, and 110% if it is over.
If you’ve made enough estimated payments from other sources to satisfy one of those conditions, you can wait until you file to settle up on the conversion. Otherwise, you need to send in a tax payment.
Changing Tax Rates
You make a good point about the current tax environment relative to what it will likely be in the future. The Tax Cuts and Jobs Act will sunset at the end of 2025, and income tax rates will revert to pre-2017 levels unless Congress does something. That is certainly a factor to consider.