Updated on January 3, 2018
Roth IRAs: When Should You Take Distributions?
The benefits of contributing to a Roth IRA are significant, as it, along with Healthcare Savings Accounts, enable not just tax-deferred investment compounding, but tax-free investment withdrawals (if certain conditions are met, see below) without a required schedule. Thus, it’s financially beneficial to house tax-inefficient investments, with a high expected return, in a Roth account and let the investments “ride”, i.e., let them appreciate through time with no forced withdrawals.
That may seem obvious, but less apparent is the answer to the sticky question, “When should I start taking distributions from my Roth IRAs?” The knee-jerk reaction might be, “As far down the road as possible,” as, again, the Roth structure has so many tax advantages to benefit long holding periods:
- Tax-free investment compounding
- No Required Minimum Distributions (RMDs) during the contributor’s lifetime
- Advantageous estate transfer rights to spouses, who retain the no RMD rule
- Tax-free withdrawals (based on 5yr/5yr rule on contributions & conversions: earnings on contributions are tax-free if withdrawals start no earlier than 5 years from the beginning of the tax year of initial contribution, and conversion principal is penalty-free on withdrawal if the same 5 year holding period applies – and shorter if the Roth contributer reaches age 59.5 within 5 years/is already that old)
However, point #4 deserves further analysis. What if you own both pre-tax IRAs/401(k) assets and Roths and sit in a marginal tax rate today that is higher than the one projected during the years you are required to take distributions from your traditional IRAs (which are taxed as marginal income)? If, in this circumstance, you take a distribution from an IRA for cash-flow needs, does it make sense to avoid taxes and withdraw from a Roth? Like the answer to any sticky question, it depends. The variables to consider are two “spreads” (the difference between two values): the distribution time spread and the distribution tax spread.
As an illustration, consider Julio, who lives in California and currently sits in the highest marginal federal and state tax brackets (cumulatively 52.9%) and is 65 years old. In his 70s, Julio expects to relocate to Florida and recognize income placing him in the 25% federal tax bracket. Julio comes from an excellent gene pool for longevity and expects to live to 95, at which time he’ll pass his assets to his son, Raul, 30 years his junior. Assuming Julio has $100,000 in IRA assets, split evenly across Roth and traditional IRAs, does it make sense to take a $10,000 distribution from a Roth or traditional IRA in these circumstances? To answer, consider the two “spreads” in question: distribution time spread and tax spread. The distribution time spread is the average additional tax-free investment time in a Roth that is lost by taking a Roth distribution today. In our example, we assume the average distribution age in the traditional IRA is 80 years old, while in the Roth, Raul is forced to take the distribution on average 15 years after his father’s death at 95, equating to a 30 year spread. The distribution tax spread is the difference between the traditional IRA tax rate today and when the funds are distributed as RMDs (assume Roth distributions meet requirements and are tax free): 27.9% in our example. So, if Julio takes a Roth distribution, he gains a positive distribution tax spread of 52.9% (he pays no taxes on the distribution) today, and pays 27.9% less in RMD taxes on that money in later years. However, he loses 30 years of tax-free compounding as a negative distribution time spread and must pay 1% in annual investment taxes during that period (assume the funds are re-invested in a taxable account, incurring a 1% annualized tax cost – on investment income, dividends, capital gains, etc.). Running a financial cash flow analysis using a 5% assumed portfolio return, the Roth distribution wins: the total, after-tax future portfolio value is highest taking money from the Roth, not the traditional IRA. The tax savings is too much to overcome with the negative distribution time spread vs. a traditional IRA: the economic difference is about $18,000 over 45 years. Thus, considering the intricacies of your personal situation is key to making the right IRA distribution decision.
In summary, while in most circumstances it makes sense to keep investments housed in a Roth IRA for as long as possible, make sure to assess your current and future tax situations if you’re contemplating an IRA withdrawal. It boils down to analysis of two spreads: the distribution tax and time spreads. Depending on your projected lifespan and that of your beneficiary(ies), if you are older than 59.5 years of age and your marginal tax rates today are higher than projected during your RMD years, a Roth distribution can make sense. It did for Julio.
Finally, the answer to that earlier sticky question is much easier if the Roth IRA is inherited by a non-spouse, in which case the IRS requires distribution of funds based on an expected lifetime actuarial table. The distributions remain tax-free.