Oct 05, 2021

IRA Aggregation: What It Is and Why You Should Care

If you own or pay into an individual retirement account, you might already know there are specific rules around how funds can be contributed, withdrawn and taxed. One such rule is the IRA aggregation rule, which states that the Internal Revenue Service views all assets held within traditional IRAs as essentially one account. But while that rule might seem pretty straightforward, the financial implications of the IRA aggregation rule can be both significant and far-reaching. Let’s look at how this rule can affect investors accumulating wealth as well as those drawing down their accounts.

 

IRA Aggregation and Roth Conversions

 To see how the IRA aggregation rule affects those accumulating wealth, it’s worth understanding how a traditional IRA differs from a Roth IRA. The biggest distinction between the two is the timing of the tax benefit. With a traditional IRA, your tax benefit occurs upfront: Your contributions and growth are tax-deferred, but you are taxed upon withdrawing funds. For a Roth IRA, it’s the reverse: Your initial contributions are taxed, but any growth and withdrawals will be tax-free. The question for most savers, then, becomes when it makes the most financial sense to claim the tax benefit – when making contributions initially or making withdrawals.

(While this is the biggest distinction between the two IRAs, it’s not the only one. It’s also worth noting that Roth IRAs have an income threshold: Single filers making more than $140,000 annually are ineligible from contributing to a Roth. Also, you can only contribute $6,000 –$7,000 if you’re 50 or older – annually to your traditional and Roth IRAs and that amount is the total you can contribute between the two, not per IRA.)

If you choose to contribute to a traditional IRA, you then have a decision on what to do with your retirement funds as they (hopefully) grow. The first option is to let the assets grow where they are on a tax-deferred basis and take the associated tax deduction. However, the specifics of your tax benefit will depend on income thresholds and whether you and/or your spouse are covered by an employer-sponsored retirement plan. For many high-income earners, traditional IRA contributions offer no tax deduction at all.

A second option is to immediately convert the assets from a traditional IRA to a Roth IRA. If a traditional IRA contribution doesn’t generate any tax benefits, then from a tax perspective, converting the assets to Roth would leave you no worse off on the front end and potentially far better off on the back end, as all of the associated growth will be tax-free in retirement. You’re essentially exchanging tax-deferred growth for tax-free growth with no additional expense. This is what makes converting a traditional IRA to a Roth IRA so popular from a wealth-building, tax optimization and estate planning standpoint.

However, IRA aggregation rules complicate this strategy. Let’s say you wanted to convert gains from a traditional IRA to a Roth IRA but already have an existing IRA funded with pretax dollars or rolled over from a previous employer-sponsored plan. In this scenario, the immediate conversion strategy loses value. That’s because the Roth conversion would be done on a prorated basis for taxation.

Here’s an example: Let’s say you have an existing IRA with $54,000 of pretax dollars. You decide to open a new IRA, fund it with a nondeductible / after-tax contribution of $6,000 and immediately convert $6,000 to a Roth IRA. Under IRA aggregation rules, $5,400 of this will be deemed taxable and only $600 will move into the Roth tax-free. The taxable nature of this distribution erodes the current and future value of the conversion strategy and may be less tax-efficient than leaving the assets where they are.

 

IRA Aggregation and Required Minimum Distributions

 Under the current tax code, RMDs are assigned to each traditional IRA the year an investor reaches age 72. This amount is derived from the account value on the last day of the prior year divided by a factor based on the age of the investor. If the investor owns only one IRA, the RMD calculation is very simple. If the investor owns multiple IRAs, however, the calculation becomes a bit more complicated.

Because the IRS views all the IRAs an investor owns as one large account, the “real RMD” is actually based on the aggregate value of all the assets held within these various IRAs. The IRS doesn’t provide this total RMD to you – it’s your job to add up the RMDs from all associated IRAs and determine the total value that must be distributed prior to year-end. Said another way, an investor with multiple IRAs is responsible for each associated RMD.

Once you’ve ascertained the full value of the RMD, you have some flexibility in how you can satisfy the RMD requirement. Making the appropriate RMD from each IRA would satisfy the aggregate total. However, you might decide to put the IRA aggregation rules to your benefit and distribute the aggregate RMD from one specific IRA. This is allowed: As long as you distribute the aggregate RMD from some combination of the associated IRAs, you will have fulfilled your RMD requirement.

This possibility has important implications for a variety of asset allocation decisions. If you own multiple IRAs, it might make sense for you to segregate growth-oriented, less liquid assets from income-oriented or more liquid assets. The account with the income-oriented, more liquid assets, for example, might be the account you’ll choose to satisfy the annual RMD from. This would allow the assets held in the “growth” IRA to avoid an untimely liquidation in the event of a market downturn.

What To Do Now

The IRA aggregation rules extend beyond these two examples and have further implications for retirees and pre-retirees alike. Working with a Baird Retirement Management advisor in conjunction with a tax professional can help mitigate the risk of running afoul of IRA aggregation rules and maximize your retirement savings.

This information is for educational purposes only and was obtained from sources believed to be reliable, but its accuracy is not guaranteed.  All investments carry a level or risk, including loss of principal.  Robert W. Baird & Co Incorporated does not offer tax or legal advice. This information is believed accurate as of the date authored.  However, tax laws and regulations are subject to change. You are encouraged to speak with your tax or legal professional as each individual’s situation is unique. 

   


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