IRA distributions

Upon reaching 70½ years of age, everybody with a traditional IRA is required to begin taking money from the IRA by April 1st of the following year. This form of mandatory withdrawal is called a distribution. From the date of your first distribution on, the IRS requires that you take a minimum distribution at least once a year. These required minimum distributions are called RMDs or MRDs. The amount of your RMD is based on your IRA account balance and your life expectancy.

After the first RMD year, the year when you reach 70½, the IRS requires you to take an RMD by Dec. 31 every year. In the first RMD year, you have until the following April 1st to take your first distribution. This means that you must take two RMDs in the first calendar year they are required.

Taking the full amount of an RMD when you are required to take it will help you avoid unnecessary penalties: if you do not take the full amount of the RMD, you are required to pay a 50% tax on the difference between the amount you took and the full amount required.

Once you begin taking distributions from a traditional IRA, you are expected to pay income taxes each year that you receive distributions. Also, if both the contribution and earnings portions came from a tax-deductible contribution, you will owe taxes on both.

Please note that Vargus & Associates and their employees or associates do not provide tax advice.

Roth IRAs compared to traditional IRAs

With traditional IRA accounts being subject to taxes, penalties and RMDs, Roth IRAs are often seen as the more desirable choice for those looking to invest. This new form of IRA has many features that may make it more attractive for some individuals, but it is also important to recognize the fact that contributions to Roth IRA accounts are made with after-tax dollars.

One of the primary advantages to holding a Roth IRA account versus a traditional IRA account is that your entire balance may be distributed tax- and penalty-free if you've held the account for at least five years and meet one of the following conditions: you are disabled, are taking out up to $10,000 to buy your first home, or payments are being made to your beneficiary or estate following your death.

Another advantage to the Roth IRA is that it does not have a required minimum distribution amount. The result of this is that a Roth IRA owner has more control and flexibility in how they manage their estate. As opposed to taking distributions that you may not actually need, Roth IRAs give you the option to leave that money to your beneficiaries.

Roth conversion of traditional IRAs

Through a process called Roth conversion, which has been allowed by tax laws, investors can convert the assets from a traditional IRA to a Roth IRA. When performing a Roth conversion, you would use either a Roth rollover or a trustee-to-trustee transfer.

While converting assets from a traditional IRA to a Roth IRA has its benefits, it may be a trade-off. For instance, you will owe taxes the year that you convert to a Roth IRA. The reason for this is that you are moving your assets from a tax-deferred account full of tax-deductible contributions to a new retirement account funded with after-tax contributions. For example, if you were to assume that you were converting $100,000 from a traditional IRA to a Roth account, and you were in the 25% income tax bracket, the year of conversion you would owe $25,000 in income taxes.

For this reason, when considering whether or not you want to convert to a Roth IRA, it is important to consider your expected future tax bracket. For many, their level of income drops when they reach retirement, resulting in a fall into a lower tax bracket. This means that the distributions from their retirement account may be less heavily taxed. Though taxation of distributions is debatable for qualified IRAs, taxation most definitely affects the value of distributions of traditional IRAs.

Traditional IRA RMDs Cannot Be Converted. RMDs from a traditional IRA cannot be converted to a Roth IRA. Any portion of a traditional IRA that is not part of the RMD, however, can be converted.

The right decision for me?

Although there are always exceptions, the general rule is that if you expect to be in the same or higher tax bracket when you begin taking distributions, a Roth IRA has the greater appeal. However, if you expect to be in a lower tax bracket, a traditional IRA would have the greater appeal.

Roth conversions were once more desirable than they are today. In 1998, which was the first full year that Roth IRAs were available, there was a one-time rule allowing investors to spread the tax impact of conversions out over the course of four years. However, this benefit was revoked the next year, and has not been in place since 1998.

While Roth conversions mean bigger tax bills when you convert, switching over to a Roth IRA may still have a greater benefit if the account exhibits a great amount of growth in the future.