By Megan Russell
The average article you can find on the Internet about either Required Minimum Distributions (RMDs) or Roth Conversions will be littered with all sorts of scary ways that you can make expensive errors. It's no wonder that most people, advisors and investors alike, shy away from mingling the two concepts by performing a Roth conversion while the owner is subject to RMDs.
That being said, with a thorough understanding of the IRS rules, performing a Roth Conversion even after your so-called Required Beginning Date (RBD) can be both easy and profitable.
A simple summary of how to meet your Required Minimum Distribution in the same year as you perform a Roth Conversion is the axiom: RMD dollars must come out first.
I call this sentence an axiom because if you follow this principle universally, you will avoid the most common mistakes. Now for the explanation.
First, what are RMDs?
For a thorough explanation of how Required Minimum Distributions work, I'd recommend reading our article "Understanding Your IRA Required Minimum Distributions (RMDs)." That being said, the quick summary is that after you reach the age of 70 1/2 (your RBD), the IRS requires you to take, at minimum, a specific distribution amount out of tax-deferred IRAs. This distribution amount is called your Required Minimum Distribution or RMD.
There is a precise calculation, based on your age and the December 31st value of your account, which is used to find out what your RMD for the year is.
Second, what is an IRA Rollover?
At any time (before or after your RBD), you are generically allowed to move funds from one IRA into another IRA without the transfer counting as a distribution.
This process is referred to generically as an IRA Rollover. There are many reasons you could be doing an IRA Rollover and there are different tax consequences or no tax consequence depending on the type of rollover you are performing.
The most common IRA Rollover is moving funds from an employer-sponsored retirement account, such as a 401(k), into a traditional IRA at a custodian of your choice. Most employer-sponsored retirement accounts only allow this transfer to happen "out of service," meaning after your termination or retirement date with the firm, but this varies by employer. This IRA Rollover process, when performed correctly, is not a taxable event.
The easiest and cleanest way to accomplish an IRA Rollover is in what is called a trustee-to-trustee transfer or a direct rollover. A direct rollover is when the funds move directly from one account to the other without the owner ever having control of the funds.
The alternative to a trustee-to-trustee transfer is riddled with many rules and potential landmines. This alternative, simply referred to as a rollover contribution by the IRS, is where one account distributes a check for all the assets it holds. Then, within the allowed time period of 60 days, you deposit that check into a different retirement account.
Third, what is a Roth conversion?
A Roth conversion is the process of moving assets from a traditional IRA (tax-deferred) to a Roth IRA (after-tax).
There are many favorable rules surrounding a Roth conversion that allow you to get the most value out of this simple transfer. Among the most important is the fact that, unlike many monetary transfers, you are allowed to undo a Roth conversion any time before you file your tax return. This undoing process is called a Roth recharacterization.
A recharacterization is a true undo. The amount you converted and did not undo is taxable in the tax year you convert, but if you recharacterize any or all of the assets, the recharacterized assets incur no tax.
Using these rules you can participate in what is called a Roth segregation strategy. In a Roth segregation, you convert more than you ultimately want to keep but segregate the assets across multiple Roth conversion IRAs. Then, after allowing these assets to grow throughout the year, you select the "winner" before you file your tax return. The winner is whichever Roth conversion account has gone up the most from its conversion basis. Because you only pay tax on the conversion basis, you are then able to get more wealth into your Roth IRA where it is never taxed again, than if you had kept any of the other accounts.
Then, you consolidate the winner into your Roth IRA to keep for the long haul and recharacterize the other accounts, putting the assets back into your traditional IRA.
Now, why do I need to "take my RMD out first"?
Strangely, the IRS views a Roth conversion through their IRA Rollover rules.
For an IRA Rollover, there is the possibility that you might make a direct rollover -- putting the account value on a check and then depositing that check into a new retirement account. This distribution would not count as satisfying your RMD if it were deposited back into an IRA.
The problem is that the IRS doesn't know whether that massive check is supposed to be you meeting your RMD or a direct rollover.
They are worried that taxpayers might use a rollover to appear to satisfy your RMD only to deposit it into a different IRA as an IRA Rollover. They want to receive the tax owed for your RMD.
To ensure this happens correctly, they have made a rule that, "Amounts that must be distributed (required minimum distributions) during a particular year are not eligible for rollover treatment" (from IRS Publication 590-B). They explain further in 26 CFR 1.402(c)-2 of the IRS code, "For example, if an employee is required under section 401(a)(9) to receive a required minimum distribution for a calendar year of $5,000 and the employee receives a total of $7,200 in that year, the first $5,000 distributed will be treated as the required minimum distribution and will not be an eligible rollover distribution and the remaining $2,200 will be an eligible rollover distribution if it otherwise qualifies."
Given those rules, the RMD portion of that check is not eligible for deposit into a different IRA. Your RMD for the year must be withdrawn from the account first and then any additional assets may be rolled over into a new account.
Although the IRS made this rule because of rollover contributions, the rules apply to direct rollovers as well. Before you can transfer funds from one retirement account to another, you must distribute your RMD for the year from the account.
Because the IRS views Roth conversions through IRA Rollover rules, before you convert anything, you must first satisfy your RMD, withdrawing those funds and keeping them out of retirement accounts.