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Liz Weston, Published August 12 2013

Money talk: Early IRA withdrawal not a good idea

Q: I am a CPA and fairly knowledgeable about investing, but I have a question about my IRAs. I am 58 and my husband is in his mid-80s. We both are retired with federal pensions and no debt other than a mortgage. My plan is to start taking money annually from my traditional IRA in two or three years. I want to reduce the required minimum distribution I will need to start taking at age 70½ and lessen the tax impact at that time. Should I put these annual withdrawals in my regular investment account or should I put them in the Roth IRA? My goal is to lessen the tax impact on my only child when he ultimately inherits this money. Does my plan make sense?

A: Your letter is proof that our tax code is too complex if it can stymie even a CPA. Still, it’s hard to imagine any scenario where you’d be better off accelerating withdrawals from an IRA and putting them in a taxable account.

A required minimum distribution “is merely a requirement to take the money out anyway,” said Certified Financial Planner Michael Kitces, an expert in taxation. “All you’re doing by taking money out early to ‘avoid’ an RMD (required minimum distribution) is voluntarily inflicting an even more severe and earlier RMD on yourself.”

In other words, you’d be giving up future tax-advantaged growth of your money for no good reason.

What might make sense, in some circumstances, is moving the money to a Roth. You can’t make contributions to a Roth if you’re not working, because Roths require contributions be made from “earned income.” What you can do is convert your traditional IRA to a Roth, either all at once or over time. You have to pay taxes on amounts you convert, but then the money can grow tax-free inside the Roth and doesn’t have to be withdrawn again during your lifetime, since Roths don’t have required minimum distributions. Whether you should convert depends on a number of factors, including your current and future tax rates and those of your child.

“In other words, if your tax rate is 25 percent and your child’s is 15 percent, just let them inherit the (traditional IRA) account and pay the lower tax burden,” said Kitces, who has blogged about the Roth vs. traditional IRA decision at www.kitces.com. “In reverse, though, if the parents’ tax rate is lower … then yes, it’s absolutely better to convert at the parents’ rates than the child’s. In either scenario, the fundamental goal remains the same – get the money out when the tax rate is lowest.”

If you do decide to convert, remember that the conversion itself could put you in a higher tax bracket.

“It will be important not to convert so much that it drives up the tax rate to the point where it defeats the value in the first place,” Kitces said. “Which means the optimal strategy, if it’s to convert anything at all, will be to do partial Roth conversions to fill lower tax brackets but avoid being pushed into the upper ones.”

Q: My husband and I are self-employed. As we pay our bills, we are often a few thousand dollars short as we wait to be paid by our clients. Until now, we’ve been using a home equity line of credit to bridge the gap. We are ultra-responsible about paying it back. But our current 10-year draw period ends this month, and our lender has denied us either a new HELOC or a refinance. Is there another product that would help us? It would be sad if the only way to maintain our life is to sell our house, but that might be where we are if we can’t find some small line of credit.

A: Talk to the bank that has your business checking and savings accounts about the possibility of opening a line of credit. This is a standard tool for businesses of all sizes but can be particularly helpful for small-business owners who have cash flow challenges. The interest rates on business credit lines are typically low, and you may be offered higher limits over time as you use the account responsibly.

If your bank isn’t interested in helping you, ask other entrepreneurs to help you find a more business-friendly financial institution. A community bank may be more flexible and more interested in winning your business than bigger, name-brand banks, but the experiences of fellow small-business owners can guide you to the best options in your community.

Liz Weston is the author of the new book “Deal with Your Debt.” Questions may be sent to 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com. Distributed by No More Red Inc.