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IN EIGHT YEARS, my wife and I will be age 72—and we’ll be locked into required minimum distributions from our retirement accounts for the rest of our lives. Nearly all of our savings are in tax-deferred accounts.
At that juncture, we’ll also have begun Social Security payments. The upshot: Our tax rate will jump significantly and, thanks to the combination of required minimum distributions (RMDs) and Social Security, our income will easily exceed our expenses.
Meanwhile, we have relatively little money in taxable accounts. That means that, each year, we typically have to tap retirement accounts to help cover living expenses. That brings me to our dilemma.
For folks with large tax-deferred accounts, a popular strategy to reduce future RMDs is to convert traditional IRAs to Roth IRAs before those RMDs kick in. But for my wife and me, those Roth conversions could trigger a big tax hit, because we also need retirement account distributions to help cover living expenses, and the one-two punch would push us into a higher tax bracket. To avoid that tax hit, we need to either live like paupers for the next eight years—or find some way to generate cash without driving up our taxable income.
Our solution: borrowing. This is an aggressive yet potentially smart strategy for folks, like my wife and me, who are under age 72, want to make Roth conversions and know they’ll soon have more income than they need, thanks to RMDs. A loan might also allow retirees to delay the start of Social Security payments, thus capturing the 8% annual increase in benefits.
To understand how this might work, let’s say you and your spouse have five years until RMDs begin and, in the interim, you need additional cash to help cover living expenses. You borrow $100,000 against your house, either by taking out a new mortgage or setting up a home equity line of credit.
Let’s assume you opt for a 15-year, fixed-rate mortgage, which today would charge some 3% in interest. To cover the next five years of mortgage payments, you set aside $40,000 from the $100,000 loan and stash it in cash investments. This frees up $60,000 to help cover living expenses.
If, instead, you had to get that $60,000 in spending money from a traditional IRA, you’d need to withdraw around $82,000, assuming a combined 27% marginal federal and state income-tax rate. But thanks to the loan, you can instead convert that $60,000 to a Roth, while also pulling out an additional $22,000 to pay the resulting tax bill—and be no worse off from a tax standpoint.
How does this strategy help you? The Roth conversion has reduced your tax-deferred account balance by at least $82,000 and likely more, because of subsequent investment growth. That means your RMD at age 72 will be reduced by $3,200. This trims that first year’s RMD tax bill by around $900 and perhaps even more if today’s low tax rates sunset in 2026, as they’re currently slated to do. Since RMD withdrawal rates increase with age, the tax savings will likely grow each year thereafter.
The biggest advantage of the strategy: Instead of $82,000 in tax-deferred money, you now have $60,000 in a Roth IRA growing tax-free. On top of that, you won’t have to take RMDs from the Roth, plus the Roth makes a better inheritance for your beneficiaries, especially under the new SECURE Act.
To be sure, at the end of five years, you also have the outstanding mortgage balance of about $71,000. You can pay that down with the RMD distributions you’re now compelled to take, plus the Social Security payments that have also kicked in. And remember, you always have the option to cash in your $60,000 Roth—which, by then, may have grown as big, or bigger, than the mortgage balance.
John Yeigh is an engineer with an MBA in finance. He retired in 2017 after 40 years in the oil industry, where he helped negotiate financial details for multi-billion-dollar international projects. His previous articles include Losing My Balance, Our To-Do List and Death and Taxes.
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But at older ages isn’t there a risk of not having the Roth in effect the required five years to gain the tax advantage? I assume that applies to conversions as well. The other factor in the RMDs is the Medicare Part B premium which can skyrocket for both spouses.
Thanks so much for writing up this strategy. We have been discussing how to better allow people to model using debt like this on our platform, so this is a great use case. Many of our users are modeling Roth conversions.
We have a lot of engineers who use our platform. I’d love your feedback if you try it out.
I know Jonathan well and he’s been on our podcast.
https://www.newretirement.com/retirement/podcast-episode-3-money-behavior-happiness/
This is another example of a person who probably listened to a financial adviser and saved too much for retirement. He should have started withdrawing from the tax deferred accounts many years before which could have been done penalty free before he was 59 1/2 under the SEPP. Like many people who save too much he says he will be in a higher tax bracket in retirement, especially when he begins taking SS