Secret Strategy for Roth IRAs


Reader question: This reader had two questions:
1.      Question: When you have to start taking annual amounts from your conventional IRA at age 70 ½, can you put that amount in your Roth IRA? 
Answer: No later than April 1st of the year following the year you turn age 70 ½, you must begin taking Required Minimum Distributions (RMDs) from the sum total of all of your traditional IRA accounts. The amount that must be withdrawn is based on IRS tables and the percentage withdrawn increases each year (roughly based on life expectancy). You are not allowed to ‘convert’ your RMD into a Roth IRA. Instead, you must report it as income on your tax return. If you have earned income, you are allowed to continue to contribute to a Roth IRA. For 2013 you may contribute 100% of your income up to $6,500 if you are over age 50 ($5,500 if you are under age 50). One advantage of a Roth IRA is that there are no required minimum distributions.
I think I know where you are headed with your question. Let’s say your RMD is $2,000 for this year. Since this is a taxable event, why not ‘convert’ the $2,000 to a Roth IRA? While you certainly are allowed to convert $2,000 of your traditional IRA to a Roth IRA (a taxable event), you’d still be required to take a $2,000 RMD…now a second taxable event! Nice try!
One strategy to consider is converting a portion of your traditional IRA each year to a Roth IRA. Often retirees are in a much lower tax bracket after retiring. Consider converting as much as possible while staying in the 15% or lower tax bracket. For couples filing jointly, the top of the 15% tax bracket is a whopping $70,700 ($35,350 for single filers). For example, let’s assume your adjusted gross income (AGI) is $50,000 in 2013. You could convert up to $20,000 of traditional IRA funds to a Roth IRA and it would be taxed at the 15% level or $3,000. Those Roth funds now grow tax deferred as long as you live and your beneficiaries, while required to take required minimum distributions based on their own life expectancy, will do so tax free. If the beneficiaries happen to be grandchildren, your grandchildren will be able to ‘stretch’ out those withdrawals over decades creating an amazing financial benefit for them. For example, let’s assume you leave your $50,000 Roth IRA to your twenty-year-old granddaughter and she took only the required minimum distributions based on her life expectancy. If she earned 9% on her investments, by age eighty-two (her life expectancy according to the IRS tables), she will receive lifetime distributions of over $2.4 million!
2.      Question: If you convert all or part of an IRA to a Roth IRA is there a waiting period before the entire converted amount plus earned interest can be treated as a Roth? I’ve heard it’s something like five years. R.D.
Answer: To answer this question I consulted with one of my partners, Kimberly Reynolds, MS, who taught income tax at the University of Alabama for five years. According to Kimberly, “When you convert a traditional IRA to a Roth, you have the five-year rule which would apply to the earnings.  Withdrawals from a Roth IRA follow an “ordering rule” which states that any withdrawals are considered a withdrawal of contributions first; conversions second; and earnings last.
Contributions. Withdrawals of your contributions from a Roth are always income tax free.
Conversions. If you convert from a traditional IRA to a Roth, the amount of the conversion may also be withdrawn at any time income tax free.
Earnings. Earnings, whether in the form of interest, dividends or capital appreciation are subject to income taxes and a 10% federal penalty if withdrawn within the first five years of opening the account. There are exceptions to the 10% penalty if you are over the age of 59 ½ or distributions are made to a beneficiary due to death, qualified disability or qualified first time home buyer.”
This is great news because it means that whether you contribute or convert funds to a Roth, you have free access to all of your money except the future earnings. And once you pass the five year mark, you have access to all of your money. However, you’ll want to avoid this if at all possible since the big benefit of a Roth is tax free growth and future tax free withdrawals.