For IRA account holders in retirement, it is generally recommended to defer distribution of funds from the account to continue tax-advantaged growth until the Required Minimum Distribution (RMD) begins at age 70 ½. But “generally” does not apply to your unique financial circumstances and may not always be the most tax-efficient strategy. There are 5 key circumstances when taking money from the IRA prior to the requirement at age 70 ½ could be more beneficial, again depending on your unique financial situation.
5) Circumstances Change
An important part of planning for IRA distributions is the fact that circumstances do change. And those changes could be from one year to the next or even one month to the next. It’s for this reason that we wait until the end of the tax year before taking the distribution or converting the funds to a Roth IRA.
The change in circumstances could be things out of your control. For those still working there is always the chance of an unexpected bonus or some type of wages being paid out at the end of a tax year. For retirees it could be as simple as an existing investment creating taxable income. It could be a simple tax law change that creates a new opportunity for IRA distribution planning. For all of these reasons we prefer to wait until year-end before finalizing any distributions or Roth conversions.
Once an IRA distribution is complete, there is likely no way to undo the distribution. There is only a small window of opportunity for a 60 day rollover of the funds if your income changes significantly. For the Roth IRA conversions there is a little more flexibility, in that you have until your tax filing deadline to re-characterize the conversion to a Roth. While the re-characterization gives you the opportunity to undo the conversion, it’s still a good idea to wait until late in the year to see how your income and deductions unfold.
Let’s look at an example of how a re-characterization could work to your benefit:
John, age 61, is retired. He plans to start some consulting work next year, but anticipates his current year income will only consist of investment dividends and interest. He assumes his current year income and deductions will keep him in the 15% marginal bracket. He even has room for another $20,000 of income that would keep him in the 15% tax bracket. He decides to convert $20,000 of his IRA to a Roth IRA. In the final quarter of the tax year, John discovers the business he plans to consult for needs his immediate help and have offered incentives for him to begin work the final two months of the year. Due to the additional income, the conversion will actually bump John into the 25% tax bracket. Fortunately, John can minimize the tax impact by re-characterizing part or all of the Roth conversion prior to his tax filing deadline. The re-characterization will essentially unwind the conversion and move the funds back to his Traditional IRA.
This is just one example of many that could impact taxable income in a given year. And it’s why we wait to make a final determination on converting money to a Roth IRA. Of course, there are specific rules on re-characterizations that need to be followed. And the re-characterization does provide for planning opportunities as well. As circumstances change throughout retirement, the IRA distribution plan may change along with it. Any plan must have the flexibility for adapting to the ever changing retirement landscape.
As with all IRA distribution strategies discussed in this series, there are many factors to consider, and there is never one single approach that will work for everybody. Personalized tax and wealth planning are crucial to ensuring your personal financial success. At Reilly Financial Advisors, our Discipline to the Power of 3 approach and integrated tax planning is key to helping our clients define and achieve their individual financial goals. Contact Reilly Financial Advisors at 800-682-3237 or firstname.lastname@example.org to learn more about a retirement strategy for you.