Scott and Pat advise a caller about how to pay less tax when taking a minimum IRA distribution.
Scott: Right now, let's go to San Jose and speak with Ondene. Ondene, you're with Hanson McClain. How can we help you?
Ondene: I would like to know ... I am going to be 67 next month and I'm concerned about a required minimum distribution when I hit 70½.
Scott: Okay. Now's a good time to be thinking about it.
Ondene: I have no clue.
Pat: That is a good...actually, a lot of people don't call until they're 70 and the planning opportunities that they had were sacrificed. So the earlier you actually start thinking about required minimum distributions, the better off you are. So let's ask a couple of questions about you.
Pat: How much is the account balance in the IRA or 401k or wherever it is? Which one is it, an IRA or 401k?
Ondene: It's a traditional IRA. I rolled it over when I retired in ... a couple years ago and there's $325,000 in there now.
Pat: Okay. And what's your income, including social security? The family income to you right now?
Ondene: Why did I know you were going to do that?
Scott: Just a ballpark.
Ondene: It's close to $5,000 a month.
Ondene: That's ... I'm going to be general.
Pat: And are you married?
Scott: And are you taking any income from your IRA today?
Scott: Okay. So here's how the law works. When you reach age 70½, and I don't know where the half-year came from, it's ... thank you Congress. But when you reach age 70½, you must start taking some distributions from all of your retirement accounts, IRAs, 401ks, 403bs, 457s, and you must start taking a distribution no later than April one, not 15 but April one, following the year in which you reach age 70½. So in 3 years, when you're 70½, the year after that, you must have distributions taken no later than April one. Pat: Here's the planning opportunity: You take a look to see what your required minimum distribution is and you project what tax rate you're going to pay at that point in time. And then you come back and you say, "Hey, what's the tax rate going to be if I took it out today and converted it to a Roth IRA and actually paid taxes on it early rather than wait for the required minimum distribution?"
Ondene: That is really the big issue here. If I died at 71, my beneficiary will then have to be worrying about the distribution and the taxes.
Scott: Well, so here's...
Ondene: I don't want to do that to them.
Scott: Well, actually your beneficiary would have a pretty good planning opportunity. So let's say you died at age 71. Your beneficiary can inherit this IRA and then take the distributions and stretch the distributions based upon their own life expectancy.
Pat: So they’ll actually have a less required minimum distribution than you do today.
Scott: But frankly, I would certainly hope your financial advisor has good working knowledge on tax law because when taxes go from 15 percent federal to 39.6 percent federal plus another 3.8 percent for the Affordable Care Act, plus the state of California which could be another 13.1 percent ... when you're looking at over half of your ... any investment earnings going to taxes, it is a huge factor when it comes to investing, the tax ramifications, whether it's on money held outside of an IRA or inside of an IRA. So ...
Pat: So if ... with the clients of our firm, we'd look at this and say, "Maybe it makes sense to actually fund a Roth IRA."
Scott: Do some conversion today.
Pat: To convert today.
Scott: You just need to run the numbers.
Pat: Yeah, based upon your marginal tax rate, how much room is in it versus waiting until age 70½, and what that looks like.
Scott: Ondene, we would strongly recommend you meet with your financial advisor and say, "I want to look at doing some proper planning with my IRA to see if it makes sense for us to start taking some distributions today and converting that to a Roth or just waiting until age 70½.
Pat: And it doesn't ... you know, if they have the base knowledge, it's not that complicated.
Ondene: All right then. So if I just...I want to make sure I understand. So if I called him and said, "Let's talk about it. Okay, as of next week, I need you to take, based on my marginal tax rate, I want you to convert say $10,000 into..."
Scott: No, no, no. We want to figure out if it makes sense to do it or not.
Ondene: Oh, if it makes sense to do it.
Scott: The way the tax rates work, the tax bracket goes from 15 percent, then jumps to 25 percent, the federal tax bracket, that is. That's a 10 percent differential, so if there is still room in your 15 percent tax bracket, that's what you want to take advantage of. That's what you want to exploit.
Pat: Now, in saying all that, here's what we find. That's in a perfect world where people are 100 percent rational and make rational decisions about everything. When I come to you and say, "We're going to convert this money from an IRA to a Roth IRA. Oh, and you don't really have to do it, but you're going to have to pay taxes on it, state and federal right now, $3,000."
Scott: Sometimes people say, "Forget that."
Pat: Some people say, "Forget that." And we say, "Well, if you wait, you might have to pay taxes on it of $4,000 or $5,000." But you may be rational.
Ondene: Oh, okay.
Pat: You may be rational.
Ondene: You have to pay it one way or the other.
Pat: You want to pay less.
Scott: You want to pay the least amount possible.
Ondene: The least amount, yes.
Scott: Absolutely. Hey, Ondene, thanks so much for calling. We appreciate your call.
Ondene: I thank you so much. Now I know what ... I've got a better idea of where I'm going and I appreciate both of you very much.
Scott: Thank you. Appreciate that.