The animated show Captain Underpants (created by cartoonist Dav Pilkey) aired a Halloween episode earlier this week. For those of you who don’t spend much time with boys under 12, the protagonists of the show are two boys, George and Harold, who have a talent for finding adventures, causing mayhem and recording both in their own, hand-drawn comic series featuring the brief-clad superhero, Captain Underpants. The antagonist of many episodes is the school principal, Mr. Krupp, whose delights in sabotaging whatever kids find fun. In this episode, Mr. Krupp sets out to cancel Halloween—in a campaign called “Hall-no-ween”—because, in the explanation, he used to bring the town council on board: “Do you want kids ringing your doorbell over and over and over and over and over and over and over and over and over and…” You get the idea. Since the episode, my husband has delighted in repeating that line over and over and over because he knows that I don’t, in fact, like answering the door over and over to trick-or-treaters. The first 20 times, which feature adorable toddlers, are tolerable, but I balk when I open the door at 9 pm to a band of barely disguised teenagers, who should be old enough to get a darn job and buy their own darn candy. My preferred solution would be to dump all our candy into a big plastic bowl at the start of the evening, leave the bowl on the steps and then turn out all our lights and put out a “Sorry, out of candy” sign when the candy’s run out.
I was reminded of these two methods when I sat down with a new client to discuss distributions from her traditional IRAs. Since traditional IRAs are funded with pre-tax money the amounts that she will withdraw from them is wholly taxable as income. The client does not need to take money from her IRAs to cover her living expense, but she had just turned 70 in September and was aware that the IRS would require her to make a withdrawal soon. I clarified that her first required IRA distribution was due before April 15th of 2021, the year after she turns 70-½. She wanted to know how the distributions worked: whether the IRS calculated the amount for her, and how she paid the taxes. She was quite anxious, as most of us are, to keep on the good side of the IRS. She had also heard about Roth conversion and wanted to know if that was right for her. I thought the best course of action was to help her understand the different ways of handling the IRAs and satisfying the IRS.
Taking required minimum distributions (RMDs) is analogous to handing out candy to every individual trick-or-treater on Halloween. The IRS basically rings your doorbell over and over and over and over on an annual basis and demands that you withdraw a certain amount from your IRA and pay them the taxes due on that portion. You calculate the amount that you need to withdraw. Basically, you take the value of the IRA as of December 31st of the previous year and divide it by a life-expectancy factor. The factor will vary depending on your age, your marital status, the age of your spouse, and whether you are the original owner of the IRA, or whether you inherited it from someone else. Note that the calculation is performed on the aggregate value of all your traditional IRAs, although you may take the actual distribution from a single account rather than proportionately from each, if you prefer. I recommended to my client that she combine, via trustee-to-trustee transfer, her four IRAs into one in order to simplify the calculation we would need to make each year and the paperwork she would need to file to create the annual distribution. I also clarified to her that no, the IRS will not do the calculation, but they do provide all the tools which we would need here. When you take the traditional required minimum distribution approach, not only does the IRS ring your doorbell every year of your life, but if you die with money left in your IRA, they continue to ring the doorbell of your beneficiary(-ies) annually for the entirety of their lives.
Taking IRA distributions annually has the attractive effect of postponing tax payments as long as possible, since each year you are only paying tax on a small fraction of your money and it may be 30, 40, 50 or more years until the IRS gets its last payment, depending on the how long you live and the age of your youngest beneficiary. Particularly if, as with my client, you don’t need the withdrawals to live on, why not make the IRS wait? On the other hand, as long as the money in the IRA is growing, you are accumulating more and more dollars on which the IRS will have a claim. What if there was a way to keep their hands off that additional growth.
In fact, there is, by converting some or all of your traditional IRAs to a Roth IRA. To refresh your memory, traditional IRAs are funded by pre-tax money, which then grows tax deferred. Because the money in your IRA is income on which you have never paid income tax, the IRS has a claim on the funds. They impose required minimum distributions because they want to make sure they get their payments. Roth IRAs, on the other hand, are funded with after-tax money. And, the way the rules are, once the contributions have been made, any growth they later accrue within the Roth is tax-free. Yes, you did hear that correctly. So, it can make sense to convert from a traditional to a Roth IRA in order to save the income taxes you would otherwise have to pay on future growth. BUT, and this is a big “BUT,” you have to understand both how such conversion works and the tax implications for the year you do it. First of all, if you are already 70-½, then you’ll want to take your required distribution before you make a conversion. Then, you have to understand that the tax on the entire amount converted is due in the year the conversion is made. So, if you convert $10,000 of your IRA in 2019 and your effective income tax bracket is 15%, you will owe the IRS $1,500. But since the $10,000 has been moved into the Roth, you cannot use $1,500 out of the $10,000 to pay your tax. Nor can you take out $11,500 from the traditional IRA, because then you would owe tax on both the original $10,000 and the added $1,500. Essentially, you have to have other savings from which to pay the tax if you are going to do a Roth conversion. You also have to be aware that a conversion of a certain size may be sufficient to push you into a higher tax bracket.
If you hand out your Halloween candy piece-by-piece each time the doorbell rings, your candy will probably last the whole evening. You may even end up with leftovers for yourself to eat while you watch the Halloween episode of Captain Underpants. If you take RMDs, you can make your tax deferral last your entire life and even further over the life of your beneficiaries. Note that the candy analogy falls apart here—there will never be a portion of the IRA that the IRS does not get a piece of. Making a Roth conversion is analogous to my approach of dumping a large amount of candy in the bowl outside. You’re giving the IRS a whole bunch of taxes up front, but they won’t bother you again after that. When the time comes, talk with your financial and tax advisors to determine which way, or which combinations of ways is best for you. Note to those parents, who may want to have a special-needs trust as the beneficiary of an IRA. It gets complicated and we will talk about that next week.