When advisors assist their clients in repositioning their assets from tax-deferred to tax-free, the following question sometimes arises: If my client does a Roth Conversion, does that count towards the Required Minimum Distribution? The short answer is no.
Let me illustrate with an example: Let’s say your clients’ tax-free road map calls for an annual shift of $80,000 from tax-deferred to tax-free. Let’s also say that in year 1, they have a Required Minimum Distribution of $20,000. Before your client can do any Roth Conversions, they are required to take their $20,000 RMD. Once received, they can now do a Roth Conversion on the remaining $60,000.
What typically becomes of the $20,000 RMD, especially if your client doesn’t need it for lifestyle purposes? In many cases, these RMDs get deposited into some sort of taxable account. So, that $20,000 moves from an environment where it only gets taxed once, upon distribution, to an environment where the growth gets taxed each and every year. Doing this only creates more imbalance in your clients’ buckets and may even prevent them from getting to the 0% tax bracket. So, what’s the solution?
If the client is still working (which is unlikely at age 70 ½), they can certainly put some portion of that after-tax RMD into Roth IRAs. At that age, it is likely they are already retired and can no longer contribute to Roth IRAs. If that’s the case, it may make sense to direct the after-tax portion of the RMD to a Life Insurance Retirement Plan (LIRP). When structured properly, an LIRP can mimic all of the tax-free benefits of a Roth IRA, without the constraints (i.e., contributions limits and income limits). Further, many companies offer LIRPs that have chronic illness benefits that allow the client to receive the death benefit in advance of their death for the purpose of paying for long-term care. In the meantime, they have unfettered, tax-free access to their surrender value as a way to supplement their other tax-free streams of income. And, of course, the death benefit gets passed on to their heirs 100% tax-free.
So, if you have clients who are currently receiving RMDs, yet also desire to do Roth Conversions, think about recommending an LIRP as a way of building their tax-free bucket while protecting against the risk of a long-term care event.
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