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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
Unfortunately, this is a problem the vast majority of Americans will not have. I believe a better strategy for those with more modest retirement savings and even for those with large retirement savings balances who have a paid for home and are at least 62 is a reverse mortgage. There is a 3 or 4 % sales commission which can deter some people. However, this effect can be offset if the retiree is going to move anyway and use a HECM for Purchase that will charge about the same commission that would be paid if the retiree was going to move anyway. The reverse mortgage does not have to be repaid until the retiree leaves the property or dies. Based on current 1 Libor rates the loan increases by 5 to 6% currently while the balance available to spend increases by the same 5 to 6% rate. This balance can be left unspent and recovered before the retiree leaves the property. Mine is paying 6% currently. Deciding whether or not to take funds out of tax deferred accounts should take into account the total tax rate to be paid in the year. Marginal rate is not always completely illustrative of what should be done in a particular year.
Thanks for the excellent article and as others have pointed out the outside the box thinking. I know there is no one-size-fits-all answer. But as my wife and I turn 64 later this year, are still working and likely to work for a few more years, I have been thinking about the question whether to convert some of our retirement savings into Roth accounts. The problem is (and I concede it is not a bad problem to have) this year and next (maybe even thereafter for a year or two, who knows) we will be in as high a tax bracket as we ever will see unless tax rates jump quite a bit in the future. So I keep wondering why we would not take tax deductions we can get this year with traditional 401(k) contributions as well as pay the extra taxes at ordinary income rates we would need to pay to convert existing 401(k) accounts to Roth accounts. I am struggling to figure out what the break even tax rate or holding period would be. Or whatever other factor I should consider. Borrowing against the equity in our house certainly helps with the cash flow, allows existing non-taxable investments to keep growing, and possibly even is tax deductible. But the taxes still need to be paid on a current basis. And one can’t even be sure a future administration and Congress won’t change the rules on Roth withdrawals at least for people who have sizable accounts.