“I need to convert to a Roth IRA to avoid RMD.”

Based on experience, my guess is that somewhere between one-third and one-half of people who think this are probably dead wrong. 

To hear it from some, required minimum distributions (RMD) are an enormous problem. Now, it makes perfect sense to me that when clients do not need money from their retirement accounts, they can harbor some resentment at being forced to take distributions and pay taxes. Disliking the RMD rules is understandable. But we often have to keep people from throwing the baby out with the bathwater. 

In many cases, it can indeed make sense to distribute or convert some funds in retirement accounts so that the family can make full use of lower tax brackets. If the retirement accounts are large enough, the required minimum distribution can kick a household into substantially higher tax brackets. Since a taxpayer’s personal Roth IRAs are not subject to those distributions, converting can lessen the amount of the distributions from traditional IRAs and other retirement accounts.

For those who will not need their distributions for cash flow, Roth conversions have great appeal; they offer tax-free growth and no RMDs. 

But many people don’t look at the particulars of their situation and likely don’t need to convert. First, RMDs in retirement are not necessarily as large as people think they are. The first one that somebody will take at age 70 and a half is usually only about 3.7% of the IRA, depending on the applicable birthdates. When the person is age 85, it’s still under 7%.

Also, if somebody has so much money that they want to protect it from taxation, they are also likely leaning conservative in their investment approach. When that is the case, the growth of required minimum distributions is further muted. By the time a person is age 85, past the life expectancy of a male and close to the life expectancy of a female, a conservative portfolio is not likely to be kicking off massive RMDs after 15 years, particularly if the distributions were not large when the person started at age 70 and a half.

At its core, the conversion decision is dominated by relative tax brackets. It is the tax rate applied at conversion contrasted to the tax rate that would apply when distributions are finally made.

We see lots of couples who, in their rush to convert to avoid RMDs, plan to convert so much retirement money that they will kick themselves into a bracket they or their heirs would likely not have reached if the funds had not been converted. 

Granted, predicting the future marginal rate is often not easy, but sometimes it is. I saw one case in which a single man paid gobs of taxes on Roth conversions he’d made before he was 70 and a half, when he could have just paid tax on the relatively modest required distributions later. He was leaving everything to his church, a tax-free entity. He’s leaving a lot less to the church now because his fear of taxes prompted him to take action that actually cost him more in taxes.