Depending on your tax situation, your investment and tax advisors may have suggested looking at converting some of your Traditional IRA assets to a Roth IRA. Potential benefits of a Roth conversion include tax-free growth and no required minimum distribution requirements for the IRA owner. Converting money from a Traditional IRA to a Roth IRA however requires that the amount being converted be subject to ordinary income taxation in the year of conversion.
If you’re in the unique situation where you’ve also reached the age of 72 and have required minimum distributions (RMDs) from your IRA, it’s important to ensure that any RMDs are taken first before any Roth conversions take place. Why is this?
Reg 1.402(c)-2,A-7(a) and Reg 1.408-8,A-4 specifically provides that any dollars distributed from an IRA are considered to be RMDs first until the entire RMD has been distributed. So, what are the results? If a Roth conversion took place before the RMD for the year was completed, the IRS will treat the amount converted as an RMD that was improperly rolled/converted to the Roth. Since RMDs are not eligible for rollover or conversion, this can result in an excess contribution penalty if not remedied.
Let’s take an example. Susan, who is fully retired and turned 73 in 2022, has a $100,000 Traditional IRA. Let’s assume her required minimum distribution amount for the year is $3,774. She talks with her financial advisor and tax professional, and based on their guidance, she wishes to do a $10,000 Roth IRA conversion in 2022 as well.
If Susan chooses to do the Roth IRA conversion first, $3,774 of the $10,000 distribution will be considered a regular contribution to the Roth IRA. But because she has no earned income that would not be allowed. If not corrected with the guidance of her financial and tax advisors, this could result in penalties being assessed. Instead, Susan should take her RMD of $3,774 first, then do a separate Roth IRA conversion of $10,000.
Ultimately, while there are a number of potentially great strategies out there, without knowledge of some of the nuances and the guidance of a professional, people can get themselves into trouble. Speaking to a financial advisor can help you avoid these potential pitfalls.