In response to the SECURE Act, a relatively new law that changed IRA distribution rules for account beneficiaries, many clients have asked their financial advisor the following question:
Can I pay taxes on Roth conversions now so that my beneficiaries pay less in taxes when they inherit my IRA?
The simple answer is, “Yes.”
Anyone can always pay money for Roth conversions, for any reason. However, they need to be willing to pay the associated taxes.
But the real question that an original owner should ask their tax advisor is:
Should I pay taxes on Roth conversions now so that my beneficiaries pay less in taxes when they inherit my IRA?
The answer to that question is a little more complicated. There are a lot of factors that might play into this. We’ll take a look at some of these considerations in this article.
After the passage of the SECURE Act (Setting Every Community Up For Retirement Enhancement Act), one of the biggest changes was the elimination of the ‘Stretch IRA.’ The stretch IRA allowed traditional IRA beneficiaries to take their required minimum distributions (RMD) over the course of their life expectancy.
For young adults or minors, that provision could have allowed for an inherited IRA to last for 50 or 60 years (or longer).
With the advent of the SECURE Act came several changes in the IRS rules. One of those changes affected the distribution rules for people who inherit an individual retirement account (IRA).
Many people who stand to inherit IRAs are now subject to a 10-year rule for distributions. This requires a full withdrawal of the IRA balance over a 10-year period.
Without proper tax planning, this can cause a significant tax impact to the beneficiary. High-earning adult children who inherit large IRA balances are especially at risk of paying income taxes at a much higher rate than the original account owner.
Roth IRAs are also subject to the 10-year distribution rule. Just like the beneficiary of a traditional account, someone who inherits a Roth IRA has 10 years to empty the entire account.
They simply don’t have the same tax consequences because those distributions are not taxable. The beneficiary of a Roth account does not pay taxes on distribution.
So if original account owners are in a lower tax bracket than their heirs, they might consider doing a Roth IRA conversion (or several). This would allow their beneficiaries can benefit from tax-free distributions out of their inherited Roth IRA.
If this is a possible option for you, here are 5 considerations to discuss with your financial advisor.
Roth conversion consideration #1: What are your goals?
This is a very overlooked, but very important part of the overall answer for IRA owners. To make effective decisions, you should be clear on what your goals are (and what they are not).
This will help inform your decisions when it comes to managing your retirement accounts.
For example, is your goal to keep as much tax money in your estate as possible? Perhaps your goal goes no further than taking care of your surviving spouse and keep his or her income tax liability as low as possible.
Here are some goals many people discuss:
- How do I pay the least amount of taxes on my IRAs?
- How do I maximize the tax efficiency of my charitable contributions?
- How can I help my heirs avoid a big tax hit on their IRA withdrawal?
Whatever the goal is, it’s important to have something you’re trying to achieve. Otherwise, you might end up disappointed in the result.
And if you have several competing goals, you’ll need to figure out how to prioritize them.
Roth conversion consideration #2: How do you prioritize competing goals?
What if you want to take care of your surviving spouse? And you want to take care of your grandchildren? And you want to keep your tax rates as low as possible?
Sometimes, it’s possible to meet several goals at one. But if you can’t, then you need to think about which ones are more important.
Having regular conversations with your financial adviser will help you keep focus on all of your priorities. Those conversations will also help you maintain perspective on what exactly you should be trying to achieve.
Roth conversion consideration #3: How much are we trying to achieve?
What is the scope of your Roth conversion strategy? It’s much easier to plan a tax-efficient strategy for a $500,000 account balance than it is for a $5 million balance.
Do you have a qualified retirement plan that needs to be factored in? A SIMPLE IRA? What other retirement assets are you trying to convert?
Regardless of what your goal is, the size of your account balance (or account balances) will have a direct impact on your ability to achieve it.
And it will absolutely impact how much you (and/or your heirs) pay in federal taxes along the way.
Roth conversion consideration #4: What’s your time horizon?
A lot of this depends on how old you are. Did you retire in your late 60s or early 70s? If so, you probably have a shorter time horizon that someone who achieved financial independence in their early 50s.
For example, a lot of business owners sell their business well before they turn 60. A former client of mine sold his business when he turned 62. Then we created a Roth conversion plan for him and his wife to convert $1 million into Roth IRAs before they have to start taking required distributions.
The great thing about having more time is that you can do more Roth conversions over time. Which allows you reduce the amount of money you need to convert each year.
By keeping your annual converted amount low, you can keep your taxable income low each year. Which begs the question-what is your tax bracket?
Roth conversion consideration #5: What is your tax bracket?
Many people pondering this question are retirees. Retirees might be in a lower tax bracket than their adult children. This is particularly true for older people whose children are well into their professional careers.
If that’s the case, then ‘tax arbitrage’ might make sense. In other words, a retiree in the 12% tax bracket who is converting a $1 million IRA can put together a multi-year Roth conversion strategy that will keep them in the 12% tax bracket.
Over the course of executing that strategy, a retiree can expect to pay about $120,000 ($1 million X 12% = $120,000) on Roth conversions. That could be much less than your heirs might pay.
Furthermore, it might make sense simply because you, as the original account holder, have access to tax-free withdrawals from your IRA for the rest of your life.
But what if I’m in a higher tax bracket? That’s a worthy question, and does merit consideration.
Of course, that’s only one side of the story. It’s worth considering your tax bracket, versus the tax bracket of your beneficiaries. First, we should consider exactly who your beneficiaries are.
Roth conversion consideration #6: Who are your beneficiaries?
It’s important to understand another aspect of the SECURE Act. That is the establishment of a new term, eligible designated beneficiaries.
What is an eligible designated beneficiary?
An eligible designated beneficiary (EDB) is someone who is not subject to the ten year rule. In other words, EDBs are still able to take required distributions over their expected lifetime. Just as if the stretch IRA provisions never went away.
There are 5 categories of EDBs.
Spouse beneficiaries are always considered EDBs. However, there are a couple of other provisions that spousal beneficiaries can take advantage of, that are not available to non-spousal beneficiaries.
A surviving spouse can always roll an inherited IRA over into her own IRA account. And a surviving spouse can elect to not take distributions until the original account owner’s required beginning date.
Other nonspousal beneficiaries
The other 4 EDBs include:
- Minor children of the original account owner. Until the age of 21. After that, the child is no longer considered an EDB unless he or she meets one of the other EDB criteria.
- Disabled persons. There are IRS rules that govern disability.
- Chronically ill individuals. Similarly subject to certain IRS rules.
- Persons not 10 years younger than the original IRA owner. This caveat could include parents, siblings, or unmarried partners of the owner.
Non eligible designated beneficiaries include everyone who does not qualify as an EDB. Non-EDBs are subject to the 10 year rule.
Let’s go back to the example of the retiree at the 12% tax bracket. If the adult daughter of that retiree inherits that $1 million IRA. Her family is in the 24% tax bracket.
Barring unforeseen circumstances, like losing her job, then 24% is probably the lowest tax bracket she can expect to remain in. Instead of paying $120,000 in taxes, she’s looking at paying $240,000 at the very least.
But this $1 million inherited traditional IRA has to be distributed over 10 years. Which means the average IRA distribution is $100,000 per year.
This raises the very significant possibility that this bumps her to the next tax bracket (32%). This means her ordinary income tax rate would go up significantly.
If for some reason, she waits until the tenth year to do anything about her IRA, then all of her IRA has to be distributed by the end of that tax year.
That would be enough to put her in the highest tax bracket. At the time of this writing, the highest ordinary income tax rate is 37%. And that doesn’t include state income taxes.
Certainly, from the perspective of the inheritor, some money is better than no money at all. But would that retiree have done things differently had he known how much more in tax dollars his daughter would have paid on that same IRA?
To determine that, you have to think about your beneficiaries’ tax situation in advance.
Roth conversion consideration #7: What are their tax brackets?
When you first establish beneficiary designations on a retirement account, you’re probably thinking of where your beneficiaries are at that moment in life.
But things change over time. And you might have that account for 30 or 40 years. An account that was set up with a minor child as the beneficiary might actually go to them after they’ve finished grad school. Or taken over the family business.
But maybe tax efficiency is not the most consideration after all.
Roth Conversion Consideration #8: What do you want?
This sounds a lot like #1. But there is a difference.
A goal is something that you’re looking to achieve. For example, I’d like to convert my entire IRA at the 22% tax bracket or lower, and I’d like to do that in 10 years.
If it’s feasible, that’s great. But if it’s not feasible, you might still want to do it anyway.
Let’s imagine that you can’t convert everything at the 12% tax bracket. But you really don’t want your children to pay taxes on their withdrawals. So you might decide to do the best you can and do the Roth conversions anyway.
It might not make the most sense tax-wise. The numbers might not justify why you’re doing this. But you might do it anyway as part of your estate planning.
That’s your money. And that means it’s your choice.
And because of that, people in the 32% tax bracket may choose to pay additional tax on their Roth conversions so their child in the 12% tax bracket doesn’t have to pay taxes on the withdrawal.
Or people in the 12% tax bracket might decide they don’t want to pay a single dime more in taxes over their lifetimes, so they let their kids figure it out. That’s fine too. It’s your money.
This article was written after several clients asked this question. There is no ‘right’ or ‘wrong’ answer. But it doesn’t mean that this question isn’t worth exploring.
Perhaps you come to your right answer only after taking some time to really think about how this might play out.
Interested in reading more about Roth conversions? Check out our Roth conversion sections!