Time to Retire One IRA Withdrawal Strategy

HUNT VALLEY, Md. (TheStreet) -- Among the theories on how to withdraw funds from an IRA in the most tax efficient manner, here are three popular concepts:

  • Withdraw some funds in your 60s so less is required to be withdrawn in your 70s based on the required minimum withdraw.
  • Wait until the end of each year before withdrawing.
  • Convert to a Roth IRA to eliminate all future taxation since tax rates are supposedly going higher.

Each concept has some merit, but assumptions are necessary to validate them.
Withdrawing from your IRA in your 60s when there is no need makes zero sense today. There are better strategies.

The idea of withdrawing from your IRA in your 60s when there is no need makes zero sense today, even if it did two years ago. The idea is to take money out and pay taxes on it so your balance is not so large when you turn 70.5 (the age you are forced to take required minimum distributions). The concept was flawed to begin with, but now is completely without merit since you are now eligible to do a Roth conversion.

Beginning last year, Roth conversions were made available to anyone with money in a tax-deferred retirement vehicle. If you are going to take money out you don't need and pay taxes on the proceeds, that money should be deposited into a Roth IRA -- period. Anyone over 59.5 years of age can always take the principal from the Roth without penalty, and if they have had a Roth for at least five years all proceeds (including income and gains) are tax-free from day one. If the converted amount is your first Roth IRA, you have to wait five years to take the income and gains, but the principal is always available.

The idea of waiting until the end of the year is a good general rule for someone who does need the proceeds during the course of the year, but there is one very serious exception to the rule. The reason the rule works in general is due to how the RMD is calculated. If your account grows during the year, the growth of the funds on the RMD would remain tax deferred in the account even after the RMD is withdrawn. If you have to withdraw $10,000, take it immediately and deposit the proceeds in a taxable account; then the funds lose any growth for the year. If the account grows by 10% that year, and you withdraw the $10,000 required amount in December, the $1,000 of growth that remains in the account stays tax deferred.

The exception is for people who are older or in poor health. In this situation an investor who dies in the course of the year and had not taken their RMD (because they always wait until the end of the year) would require the beneficiaries to take the RMD pro rata and pay the appropriate taxes. For people over 80 years of age or those in poor health, try to get the RMD at the beginning of the year. This assures you the RMD will be taxed to the account holder and not the potential beneficiaries. The reason this is important is that the beneficiaries are normally children in their maximum tax bracket of their life or, if the account holder dies early in the year, it would be unlikely they would have a significant amount of income taxable in that year.

There are exceptions to everything, so the key here is to determine as you get older who would be best to pay taxes on this year's RMD -- the account holder or the beneficiaries? If it's the account holder, take the RMD as early as possible, but if it's the beneficiaries, wait until year-end.

If you're considering taking advantage of a Roth conversion, ask what tax rate you'll be withdrawing funds at and what theoretical tax rate you or your children would have paid in the future when you withdraw from the tax-free Roth.

Here's an example:

John has a $100,000 IRA and wants to analyze which is better -- keeping the funds in a Traditional IRA or converting to a Roth IRA. An analysis is done and it is determined John will pay 30% of the funds in taxes or $30,000 on a conversion.

John had better have $30,000 from other monies to pay the taxes, or the conversion becomes significantly less beneficial. He'll be converting $100,000 into his new Roth and taking $30,000 from bank accounts or other investment accounts to pay the taxes, not just rolling $70,000 over to his new Roth and using the other $30,000 to pay the tax. If we assume the future potential tax rate on these funds in the IRA would be 30% or more, a conversion will almost certainly make economic sense.

In addition, John will no longer have a requirement to take a minimum distribution for the rest of his life from the new Roth. If John were to assume his tax bracket would be less than 30%, the Roth conversion would be less likely to be the better course of action.

Many commentators are saying carte blanche tax rates are going higher, and that may be a serious mistake. Take for example the Simpson-Bowles budget commission simple tax with a maximum rate of 23%: John's 30% conversion would not be a good deal, but large income conversions could be taxed at 40% or more in some states. What if the future withdrawals are made from a tax-free state? What if our government went to a value-added tax or sales tax and a low income tax rate? What if government decides to eliminate the benefits of the Roth IRA's tax-free growth? Nowhere in the Roth IRA law does it guarantee that a Roth IRA will be required to be in the tax laws forever.

The key to Roth conversion strategies is to take advantage of the potential of tax-free growth if you can afford to pay the taxes on the conversion, but don't assume you can see into the future and bet it all on the Roth conversion unless you have other economic reasons to do a conversion -- like someone who has a taxable estate with more than 75% of the estate in traditional tax-deferred retirement accounts.

As always, there are no absolute rules here. It's wisest to seek professional tax advice before making any decisions.

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Andrew Tignanelli, CFP, CPA, is president of Financial Consulate, based in Hunt Valley, Md., and a member of NAPFA, the National Association of Personal Financial Advisors.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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