Required Minimum Distributions: The Driving Factor Behind IRA Withdrawals
What motives an IRA owner to make a withdrawal from their retirement account? It’s easy to assume the answer is the need for retirement income, but the most popular reason is actually a legal one — the need to take a required minimum distribution.
New research from the Employee Benefit Research Institute (EBRI) found that almost 24% of individuals who owned a traditional or Roth IRA took a withdrawal in 2016 — the latest year for which data is available. EBRI said the IRA withdrawal percentage was primarily driven by individuals who were 70½ or older who owned a Traditional IRA and who were are required by federal law to take required minimum distributions (RMDs).
Indeed, EBRI data found the vast majority of withdrawal activity came from traditional IRAs, with 27.1% of the group taking a withdrawal in 2016. In contrast, the percentage of Roth IRA owners who made a withdrawal was a mere 4.6%.
Among IRA owners who were under the age of 60, fewer than 12% of any age group took a withdrawal, while fewer than one-quarter of IRA owners ages 71 or older were found to have withdrawn an amount from their traditional IRA in excess of their RMD.
At PENSCO, where we custody assets for our clients’ self-directed IRAs, we want investors to understand the implications of their retirement investment decisions. We have seen clients who owned traditional IRAs convert to Roth IRAs after deciding they do not want to be required to make withdrawals starting at age 70½. Roth IRAs are not subject to RMDs.
For investors weighing a conversion, there are many factors to be aware of, including tax implications.
In a Traditional IRA, funds grow on a tax-deferred basis, while they grow tax-free in a Roth. If you convert to a Roth IRA, you trade the tax-deferred aspect of your Traditional IRA for an upfront tax payment on the funds you convert.
The key — as always when it comes to retirement planning — is to consider your specific tax situation both now and in the future, and your ability to pay any upfront taxes due at conversion.
Numerous online Roth conversion calculators can help you run through scenarios and make estimates about your projected tax liability. At PENSCO we recommend that you consult with a trusted tax advisor who can ensure you don’t unwittingly trigger an unfavorable taxable event.
The mechanics of a Roth IRA conversion
When converting from a Traditional IRA to a Roth IRA, investors have many options, including the following:
- Do a conversion with the same custodian who maintains your Traditional IRA by establishing a Roth IRA and requesting the conversion.
- You can choose to rollover only a portion of your assets. This allows you to manage the tax liabilities that come along with a conversion.
- Choose a trustee-to-trustee rollover conversion. Your Plan Administrator or financial institution will do a direct rollover from a pre-tax account (e.g. Traditional IRA, 401k, 403b, etc.) to a new or existing Roth IRA.
Three potential red flags
Keep in mind that circumstances exist where converting from a Traditional to a Roth IRA could hurt you. Here are three:
- You don’t have funds to pay the upfront tax liability. When converting from a Traditional IRA to a Roth IRA, the conversion amount may be subject to taxes. PENSCO recommends that you speak with your tax advisor to determine if the tax obligations associated with a conversion outweigh the gains you may receive from it. There may be an opportunity cost in terms of missed investment returns due to withdrawing funds from your retirement account.
- A conversion may push you into a higher tax bracket. The goal in converting a Traditional IRA to a Roth is to save on taxes over the long-term. The tax hit you take upfront should be offset by the opportunity for your funds to grow tax-free and be withdrawn without being subject to taxation later. But if the amount of taxes due on conversion is significant enough, any long-term savings could be a wash or offset enough to leave you worse off since that’s money that isn’t available to grow in your retirement account.
- Once the conversion is complete, it cannot be undone. Beginning with the 2018 tax year, undoing a Roth conversion is no longer permitted.
Whenever planning for retirement, it makes sense to work with a tax or financial professional who can walk you through the pros and cons of your decision, and help you decide if a Roth IRA conversion would be in your best interest.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.
Editor’s Note: This is an updated version of a post we originally published in September 2015. We welcome new comments and questions below.